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Thu, 23 Jan 2020 07:33 GMT

What is Islamic Banking and Finance?


Jenna Kleinwort

Thu, 09 Jan 2020 13:15 GMT

Since the global financial crisis of 2008 and the failure of the conventional banking system, interest in Islamic banking has increased, particularly in whether the Islamic system is more crisis-resilient than its counterpart in the west. European countries have in recent years become more accommodating towards Islamic financial institutions. In 2014, the UK was the first western country to issue a Sukuk, an Islamic bond.

History of Islamic Banking and Finance

In the 1960s, with economic growth and many countries gaining independence from colonial rule, the need for sources of money and funding increased. This was when the first widely recognised Islamic financial institution, the Mit Ghamr savings project in Egypt, was established. It was a cooperative organisation, issuing loans for productive business purposes. In 1971, it was incorporated into the Nasser Social Bank.

The Islamic Development Bank was founded in Jeddah, Saudi Arabia, in 1975, to provide funds to member countries. Since then, the Islamic banking system has spread rapidly. The first commercial Islamic bank, Dubai Islamic Bank, was established in 1979. Since 1975, more than 500 Islamic Banks have been founded, the majority of them located in Muslim countries.

The principles of Islamic Banking

The Islamic banking system is based on the moral principles and underpinnings of the Qur’an. Essentially, Islamic banks perform the same services as regular banks, the difference being that their services are always structured according to religious implications.

The Islamic banking and finance system is based on six pillars. These are:

1. Riba is forbidden. Riba, or any predetermined interest on money lending, is prohibited. Islamic Banks therefore provide their products and services without taking any interest. The only loan in Islamic banking is the Qard al hassan, which is a benevolent loan on which the lender does not charge any interest at all. Some scholars go as far as to say that the lender cannot receive any benefit at all in return for lending money.

2. Profit and loss sharing. All transactions must be based on a system of profit and loss sharing (PLS). Both the provider and the user of capital should jointly share the risk of their business activities: the depositor, the bank and the borrower all share the risks and rewards. In conventional banking all risk is taken on by the entrepreneur, even in the case of losses.

3. Money holds no intrinsic value. All financial transactions need to be asset-backed to prevent the possibility of simply making money out of money, since money is assumed not to have any value in itself.

4. Risk or speculation is forbidden. Gharar (risk or speculation) is prohibited, and all parties involved in a contract need to have perfect knowledge of the counter-values (such as the price or the commodity being deferred) and the transactions processed. This principle should protect the weaker parties in the contract from being exploited by the more informed and thus more powerful parties. Options and futures, which are very risky financial products, are thus forbidden by their very nature.

5. Sharia’h compliance. In the Islamic finance system, all contracts in order to be valid and binding must be in compliance with Sharia’h and its moral values. Projects that involve any conflicting morals (such as businesses in the alcohol or gambling industry) cannot be invested in.

6. Sanctity of contracts. All transactions, be it in the form of sales (“bay”), hire (“ijara”), gift (“hiba”) and loan (“ariyab”), need to be regulated by a contract, in which all relevant information must be stated.

Article based on: “Introduction Islamic Banking & Finance” by Kettell, Brian (2008)

Middle East