Islamic Banking
Islamic Banking is a collective term used for all the financial activities that are Shari’ah (Islamic law) compliant. The most prominent feature of Islamic banking is not accepting or paying money/compensation just for owning and lending money. This is considered haram (not permissible under Shari’ah). The main principles of Islamic Banking (Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan)[1] are:
(i) Prohibition of interest (Riba) in all forms of transactions; Undertaking business and trade activities on the basis of fair and legitimate (Halal) profits; (ii) Giving Zakah (alms to the less fortunate, usually 2.5% of annual income of an individual); (iii) Prohibition of Monopoly; (iv) Cooperation for the benefit of society and development of all Halal aspects of business, trade and investment that are not prohibited by Islam.
The operations of Islamic banks thus is significantly different from commercial banking. Let us investigate two main activities of a Bank, namely 1) Accepting Deposits and 2) Advancing loans.
Islamic banks accept deposits two types of deposits (islamicbanker.com Web)[2]:
(a) deposits not committed for investment which take the form of current accounts or savings accounts; and (b) deposits committed for investment which are called Investment Accounts.
Compensating for these deposits as per Shari'ah: a. Deposits that are classified as ‘savings’ are not lent out. As per law, these deposits need not be compensated for by Banks, but Banks usually give out gifts or other benefits like money for small projects in lieu of these deposits. Banks may however give a part of their profits to these account holders(sometimes as much as 5-6% is paid). b. Money deposited in the Investment account is invested by the bank in projects that need funding. The compensation for this kind of investment is in the form of a profit sharing(strictly from the profits of the project at hand) arrangement between the parties that can be in any ratio. This kind of arrangement is called a Mudarabah. Thus the second function of Bank, namely lending only takes place in this form.
As the case is different for commercial banking aspects, internal wealth management and investment activities of the Bank also differ. As banks cannot just lend money for interest, equity participation or Musharkah is a popular alternative. Banks also advance Letter of Credit (for timely payment after the goods are received, no money is charged) and purchase property/real estate with a profit sharing arrangement with the party in need.
According to Sharia'ah not permissible activities include gambling, engaging in alcoholic beverage trade and the pork meats industry. Thus money cannot be invested or accepted from any of the above activities. This makes all the derivatives not permissible (as the outcome has a risk factor attached to it).
Though these are the general features of Islamic Banking, every country has its own interpretation of law leading to differences in banking practices. To overcome this irregularities the International Islamic Financial Market—a standardization body has been created. Accounting standards have also been published by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) since 1993 (Khan 6)[3]. However standardisations still remains an issue.
Sources:
[1] Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan
[2] "How Islamic Banks Operate - IslamicBanker.com." How Islamic Banks Operate - IslamicBanker.com. Web. 22 Feb. 2016.
[3] Khan, What Is Wrong with Islamic Economics?, 2013: p.6
