LONDON: Islamic banking is essentially a faith-based system of financial management, which derives its principles from the Shariah.
The Shariah position is clear. What is objected to in the conventional capitalist form of interest is that it is fixed and predetermined, and the working partner (or the borrower in Western terms) is liable to pay that, no matter the performance of the business.
Islamic finance is based on the principles that money alone cannot be used to make more money, in other words that no interest may be charged on loans; that lenders should share in the risks and profits of the enterprise; and that wealth-creation is for the improvement of the whole of society, and not merely for the benefit of a small elite.
Interest (Riba) literally means “an increase” or “addition.” Technically it denotes, in a loan transaction, any increase or advantage obtained by the lender as a condition of the loan. In a commodity exchange it denotes any disparity in the quantity or time of delivery.
In Islamic banking, interest is expressly proscribed and is the single most important feature that distinguishes Islamic from conventional banking. Other core Shariah proscriptions are Gharar (deception or ignorance in transactions through non-disclosure of the full facts relevant to any part or the whole transaction); Maisir (gambling); and investment in a range of banned activities such as casinos, gambling, pornography, breweries, and interest-based financial services.
Non-Muslims, especially regulators, find it difficult to understand why Islamic banking does not have uniform Shariah standards. Islam has four main Sunni schools of thought (Madhabs) — the Hanbali, Shafi, Maliki and Hanafi Schools of Thought — and the Shiite Jaafri School of Thought, which have different interpretations relating to certain aspects and contexts in which laws are applied, including financial laws. However, all five schools are unanimous on the basics relating to financial and investment principles. Yet there is no set of codified laws to reflect this unanimity.
The Shariah principles of financial management were set out by the Prophet Muhammad (peace be upon him) in his farewell sermon, when he talked about the ideal system at which Muslims should aim. Various forms of an Islamic financial system have been practiced during the fourteen centuries of Islamic history.
In Islam, money is seen as a measure of value through which there can be an exchange of goods and payment of debts. Originally the value of money was covered by gold, but with the introduction of paper money its value became localized to the particular state issuing it. This is why in Islamic finance the bank has to back up all transactions with a tangible asset.
In an Islamic trade finance contract such as Murabaha (cost-plus or mark-up financing), for instance, the bank actually buys the goods on behalf of the client. This means that the bank has title or ownership of the goods until the payment is made. The responsibility of ownership entitles the bank to a mark-up in the re-sale of the goods to the client.
In conventional banking, money is a product, which you can buy and sell, and trade and make money. A conventional bank buys money from depositors cheaply, say at 2 percent and it sells the money expensively by lending to other customers, say at 6 percent, and makes the margin.
Conventionally also, the depositor is a lender to the institution. Deposit funds collected constitute an ultimate liability, as the principal plus a fixed and pre-determined rate of return (deposit interest income) is fully guaranteed by the bank (underwritten by the bank’s assets). A depositor’s balance in a conventional bank is always going to be a liability, and as such will always be on the balance sheet.
In Islamic banking, the depositors are account-holders who participate in the risk-taking, according to the type of account. The deposit resembles an “open-ended mutual fund”, authorizing the bank to manage the funds in the best possible manner in return for an agreed management fee but at the entire risk of the depositor.