Islamic banking is a unique banking system that follows Sharia laws. The laws stipulate rules of operation and provide strict prohibitions. Where the regulations need to be clarified, learned scholars in Sharia and the Islamic culture are consulted for advice. Furthermore, bankers can follow precedence from similar transactions or their independent reasoning to discern the best approach to a transaction.
Although Islamic banking is an emerging finance option, the banks control over 2 trillion dollars. Moreover, the sector grows by 15-20% each year. Contrary to popular opinion, Islamic banks are open to everyone. You don’t have to be Muslim. However, the laws apply to everyone, despite their religious background. Therefore, knowing what’s allowed and what’s prohibited is essential.
What’s Prohibited
The prohibitions in Islamic banking provide a better understanding of what makes the bank unique.
Interest charge
According to Sharia, charging any form of interest on a loan is usury, and it’s prohibited. Lending money with interest charges is viewed as exploitative and only beneficial to the lender. As a result, the loan facilities offered through Islamic banks don’t accrue any interest.
Forbidden activities and items
Several activities and items in Islam are considered haram or forbidden. For example, Islam does not permit the sale and consumption of alcohol. Moreover, eating pork or any products made from pork is strictly prohibited. As such, investments in these activities and items are not allowed. Therefore Islamic banks cannot issue loans or facilitate transactions involving forbidden items or activities.
Speculation
Any form of speculation or gambling (also called maisir) is strictly prohibited by Sharia. As a result, Islamic banks don’t get involved in contracts whose stability depends on uncertain future events.
Risk
Risk management is one of the principles that guide Islamic banking. As a result, contracts with excessive risks/ uncertainty are a no-go zone for the banks. Gharar measures the legitimacy of risk in an investment and informs the next course of action. Consequently, risky investments like short selling are prohibited in Islamic banking.
What’s allowed
Since Islamic banks offer prohibitions on some standard banking principles, how do they make money?
Equity participation is the backbone of Islamic banking. This principle allows the bank to get into a contract with the borrower to share the risk and profits of investments. As a result, everyone benefits when there are profits and loses when losses are made. Nonetheless, there are several ways Islamic banks uphold equity participation.
Profit and loss sharing partnership, Mudarabah
Mudarabah is a partnership arrangement where the bank/ financier provides the capital, and the borrower takes responsibility for the management and investment of the capital. In the end, profits are shared between the parties in the agreed ratio.
Profit and loss sharing joint venture, Musharakah
In a joint venture, the two parties contribute capital and share the profit and loss proportional to their investment. There are two types of Musharakah.
The diminishing partnership allows the bank to transfer equity back to the investor in exchange for payments. After the last payment, the investor has full equity control over their asset.
The permanent Musharkah is a joint venture that has no termination date. As a result, the contract remains functional for as long as either party agree to continue with operations. Musharraf is often used for long-term projects.
Lease/ijarah
Lease agreements involve the bank leasing a property under its name to the investor for a specific duration of time and collecting rental income from the agreement. At the end of the lease agreement, the bank transfers ownership of the property to the lessee. Everyone eventually benefits.
Islamic banking has the advantage of servicing loans that help a business. Their main objective is to see the investor succeed. It’s a better approach to banking.
