The Complete Guide to Islamic Finance and Banking
What is Islamic Finance? Islamic banking is a banking system which adheres to the provisions and principles of the Shariah. Let me describe it with an example, a key feature of conventional banking is the receiving or giving of interest, which is specially prohibited by the Shariah. As an alternative, it’s heavily based on trade and is asset backed. While the outcome of financial deal is the same, the steps taken towards achieving, that deal is different to ensure fulfillment with Islamic law. Islamic banking also prohibits any sort of venture in businesses that are considered haraam or against Islamic principles. It is largely believed that these values have been derived from the Quran and have been practiced since then.
The first successful example of an Islamic Bank was perhaps a financial institution called Tabung Haji in Malaysia which came into existence due to high demand of interest free money for holy purposes (pilgrimage Hajj) since this was not possible by way of conventional banking organization. Consequently, in 1963 Tabung Haji came into being with total depositors of 1,281 which grew bigger to 8,67,220 depositors and with deposits over 1 billion Malaysian dollars. This resulted in creation of more Islamic banks especially in Egypt where small scale Islamic Banks existed since 1960s, providing financial services to the rural areas. The success of these banks resulted in the formation of the Naseer Social Bank in Cairo in the year 1972. Around the same time an International Islamic Bank for Trade and Development was projected, which led to the creation of Islamic Development Bank with a vision to promote economic development of the Muslim society in accord with the Shariat laws.
How Islam’s Sharia Law Applies to Finance and Banking Practices:
Shariah compliance is crucially important element of Islamic finance, with Shariah supervisory boards or advisory established to ensure this. The decisions of these autonomous boards are obligatory, and they are required to guide any institution towards Shariah compliance.
Institutions cannot state they are practicing Islamic financial business unless it has a Shariah board or Shariah committee consisting of qualified scholars who possess the necessary skills and are of high reputation.
In Islamic finance, practiced at an international level, there are two standard setting bodies:
- The Islamic Financial Services Board (IFSB).
- The Accounting and Auditing organization for Islamic Finance Institutions (AAOIFI).
These boards work together with organizations such as the World Bank or the International Monetary Fund (IMF) to encourage Shariah compliance across Islamic finance globally.
Examples of Islamic banking structures:
The following simplified and basic Islamic banking structures make up more or less of 70 to 80 percent of all Islamic finance arrangements globally:
- Ijarah or leasing arrangement: An agreement where a party buys an asset and leases it to a counter party. This is executable through operating lease or finance and it can be used for real estate financing.
- Marabaha or sale and margin: A Shariah-compliant sale transaction where the mark-up and profit is explicitly mentioned from the outset. This is the most widely accepted and common structure in Islamic finance.
- Mudarabah or investment: Is a profit & loss sharing joint venture where one party provides expertise and the other party is the capital provider. This is used for Islamic products, such as overdraft facilities, savings and current accounts etc.
- Wakala or agency: This is an agency agreement where a principal appoints an agent to execute certain tasks against a prearranged fee. This is used for several Islamic products including, export financing and fixed deposits.
Islamic Law and Business Principles for Muslims or the Five Pillars of Islamic Finance:
- Prohibition of interest or Riba: Islam considers lending with interest payments as an unfair practice. The avoidance of Riba is a key part of Islamic finance. In simple terms, Riba is measured as an advantage for one party i.e. the creditor at the expense of another i.e. the debtor for no appropriate consideration.
- Prohibition of unlawful services and commodities: Islamic finance forbids getting involved in any activities associated to unlawful goods and services, including all related chains of distribution and production. For example, this includes activities related to gambling, weapons, tobacco and alcohol.
- Prohibition of excessive risk and uncertainty: Islamic finance doesn’t allow for excessive risk, prohibiting uncertainty in quantity, quality, maturity and other sales terms. All these aspects’ of a transaction must be clearly stated and transparent from the beginning. The underlying principle behind the prohibition of uncertainty is to ensure full consent and agreement of the parties in a contract.
- Need for an underlying asset: In Islamic finance, a bank either acts as a seller or an owner, and as a result the asset is of great significance. Every transaction must have an underlying asset, without which the transaction is void. An underlying asset could be a fixed asset, such as investment property, or a financial asset, which might take the form of equity.
- Profit and loss sharing: Islamic finance is, in principle, a profit and loss sharing system. While it prohibits interest (Riba), it permits trade and profit and loss sharing equipments. These are structures that diverge from the traditional concept of lending, allowing the association to turn from lending into an investment. The two main products in profit and loss sharing forms of financing are Musharakah and Mudarabah.
The general practices of Islamic finance and banking came into existence along with the foundation of Islam. Though, the establishment of formal Islamic finance occurred only in the 20th century. At the present time, the Islamic finance sector grows at 15% to 25% per year, while Islamic financial institutions manage over $2 trillion. The main difference between conventional finance and Islamic finance is that some of the principles and practices that are used in conventional finance are firmly prohibited under Sharia laws.
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