Islamic Banking Essays - Credit, Islamic Banking And Finance

Islamic Banking INTRODUCTION The basic concept of Islamic banking which is also known as 'interest-free banking' is based on basic ethical standards with just one main difference- Muslims are not allowed to pay or receive interest. This does not mean that business activities or making a profit are not encouraged, they are but as long as they dont involve interest in any form. To fulfil this purpose, financial instruments have been introduced by the Islamic financial institutions to satisfy these requirements. An example that can be seen is that equity financing is used instead of debt financing. Furthermore, instead of giving a fixed interest rate on the savings account, Islamic banks offer a share of the bank's profit, as a return on deposits and this is around 5% annually. HISTORY The modern banking system was introduced into the Muslim countries in the late 19th century when most of these countries were performing that well economically as well as politically. These banks founded branches in the capital cities of major Muslim countries to cater their business needs. However, the branches were limited to the capital cities and the other surrounding cities were totally ignored by the banking system. Nevertheless, most local businesses still refrained from engaging with these commercial banks, mainly for religious reasons. The reason behind this is that banks operate on the basis of charging interest, a concept totally forbidden by Islam. As time went by however, it became challenging to avoid commercial banks. They were more efficient in certain banking aspects such as money transfers and current accounts, but borrowing loans and opening saving deposits were still avoided due to the prohibited interest issue. As the second half of the 20th century has witnessed, any business-related transaction almost always involves a bank and hence, avoiding the modern banking system has become virtually impossible. Banks extended into local communities and thus, forced themselves into almost every kind of business and their related transactions. This is when many Muslim intellectuals recognized the need for an Islamic banking system that will serve the needs of Muslims from the business point of view and at the same time respecting the codes of Islam. Islamic banking as an institution has been around for 25 years but interest-free banks have also been tried before. There was one such bank in Malaysia in the mid-forties and one in Pakistan in the late fifties. Neither of them survived. The early seventies saw the institutional involvement. The Islamic Development Bank, an inter-governmental bank was established in 1975. The first private interest-free bank, the Dubai Islamic Bank was also setup in 1975 by a group of businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan. Twenty-five years since the establishment of the first Islamic bank, more than 150 Islamic institutions have come into existence. Though most of these are in Muslim countries, there are some in Western Europe as well as in North America and Asia. PRINCIPLES OF ISLAMIC BANKING The Islamic banking system follows certain, yet simple, rules set by the Quran and the Shariah (Islamic law), which if deviated from the system becomes un-Islamic. These are summarized as follows: 1. Any predetermined payment or benefit over and above the actual amount of principal is prohibited: Islam allows only the type of loan in which interest of any form is not charged. Interest in this case is in either monetary form or other beneficiary forms such as using the borrowers property, etc. in return for the lent money. In other words, any type of benefit received by the lender from the borrower in return for lending the money is prohibited. This is different however from the concept of profit-sharing which will be explained next. This is different from the typical loan types of commercial banks which impose interest on loans in some form or the other. 2. The lender must share in the profits or losses arising out of the enterprise for which the money was lent: One of the basic concepts of Islamic banking is to share profits as well as losses. In this way, the lender and borrower become partners rather than creditor and debtor. The incentive behind this is to make both parties