What is Islamic Banking ?

Many religions across the world have prohibited the use of money as a mechanism to make even more money. The concept of interest is banned in Christianity, Judaism as well as Islam. However, in the modern day world, only Islamic nations and individuals still follow the rules which prohibit collection of interest.

Entire nations in the Middle East, Northern Africa and South East Asia did not have the concept of a bank. It was only in 1963 that the first Islamic bank was set up in Egypt. Later, in the next decade or so, more Islamic banks were set up in countries like Malaysia. In the modern day world, Islamic banking has spread far and wide and is followed in many countries. In this article, we will discuss what Islamic banking is and how it helps Muslims meet their financial needs while ensuring that religious laws are not broken.

What is Islamic Banking ?

Islamic banking is the operation of banks which are consistent with the Sharia law. Since the Sharia law prohibits the collection of interest as well as any transactions which allow speculation, it is in conflict with the basic tenets of banking. Therefore the challenge in Islamic banking is to meet the financial needs of people while staying in line with the Sharia law.

Islamic banks seem to have found a business model which allows them to do so. This business model is basically made of three different modes. These modes further branch out into banking products that are used by individuals. The three modes are as follows:

Partnership Based Mode

Islamic banks cannot charge interest to the customers. However, they are allowed to charge a profit when they sell products. Hence, when a Muslim customer needs to buy a house, they can approach banks for finance. The bank can first purchase the house in its own name. Later, the bank can resell the house to the customer. While conducting this resale transaction the bank can charge a good amount of profit margin. Also, the bank can provide installment payment facility to the buyers. The buyers can therefore pay the banks in installments just like they would do if they took out a mortgage.

However, the loans made by Islamic banks are different than the ones made by usual banks. Since there is no concept of interest, there is obviously no concept of amortization. Hence, interest is not charged on a periodic basis. Instead, it is charged as a fixed amount and is spread out over the multiple installments that the buyer has to pay. The basic nature of the borrower lender relationship is changed to a buyer seller relationship to ensure that it is in line with Islamic principles. Also, Islamic laws prescribe some tenets which must be fulfilled for the sale to be valid. For instance, items which do not exist cannot be sold and the sale must be final and absolute etc.

Trade Based Mode

In the trade based mode, the bank may provide finance as an advance payment to the customer. This payment is for goods which have to be delivered at a later date. The advance payment can be lower than the spot price of goods which are available in the market.

Therefore, a bank can provide finance which is less than equivalent to the price of goods and the borrower has to deliver goods to the bank. The bank can then resell the goods at the spot price to the borrower. The difference between the lower amount advanced by the bank and the higher sale proceeds earn by the bank result in profit being earned by them. Therefore, the bank acts as a trading partner who purchases the products at a lower price and then sells them back at the correct price. Money generated by the bank is therefore the result of proceeds of trade and it is not in the form of interest which is outlawed by Sharia.

Rental Based Mode

The last type of mode is the rental mode. In this mode, the bank purchases the asset on behalf of the customer. They then lease the same asset to the customer for a given period of time. The customer usually does not have the option to cancel the lease during that given period. At the end of the lease period, the asset is then sold to the customer at a pre-determined nominal price via a separate sale agreement.

This type of arrangement is often used for automobile financing. The bank leases cars to the customers who can then use it for a specified period. After the period is over they can purchase the car from the bank for a very small price.

Thus, Islamic banks do not collect any money in the form of interest. However, they are still able to meet the financial needs of individuals who want to buy a car for instance!

Apart from the above mentioned products, Islamic banks have several products which are on offer. The need of the modern consumer has led to the creation of multiple ways of financing new products while still being compliant with the Sharia law. Also, Islamic banking is spreading across borders and is becoming popular in many countries with a sizeable Muslim population. Islamic banks have started coming up in countries like India as well which do not follow Islam as the state religion.


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