How do Islamic Banks Operate?

The Islamic banking system operates within a framework that adheres to tenet-based principles of Islamic commercial law. The fundamental tenet, which all Islamic banks emphasize, is the prohibition of ribā in all equity, asset, liability products and services. The payment or receipt of ribā in any form constitutes an invalid transaction, and Islamic banks have to be aware that it must operate without offering any interest-based products, contracts, services or transactions in any form. The absence of ribā in Islamic banking poses the question as to how Islamic banks can offer an alternative in comparison to their conventional counterpart, in order to offer a viable alternative for capital and international financial markets and investors.

This is where the Islamic financial principle of profit-and-loss sharing under the muḍārabah contract comes into practice, as all Islamic banks have to operate with the implementation of profit-and-loss sharing in replacement of an interest-based system. All Islamic banks have to adhere to the prohibition of a fixed payment or any acceptance of interest for loans of money in their operations, as a Shariah compliant bank that adheres to the principles of Islamic finance.

An Islamic banking institution not only seeks to make money for the banking institute by lending out on capital but also adheres to the ethical principles set out by the Shariah. According to Islam, it is prohibited to lend money with interest and Islam sets out the rules on this in order to prevent ribā-based transactions. Islamic banks work in accordance with a profit and risk sharing strategy and use it as a method of trading rather than transferring risk, which is often witnessed within conventional banking institutions.The concept of profit-and-loss sharing utilized through the muḍārabah contract is implemented in the smooth running of a fully-fledged Islamic bank. Other key concepts which may be used in the operations of Islamic banks are wadī‘ah, which is safekeeping; mushārakah, which determines joint ventures; murābaḥah, the cost plus; and ijārah, which means leasing in Arabic.

An Islamic bank works differently in offering a different method of order from conventional banking products and transactions. Islamic banks that are selling a product such as an Islamic mortgage may buy the property from the seller outright and then go on to resell the property to the potential buyer so that it avoids the payment of ribā or loans of excess profit. The buyer is then given the option to pay rent to the Islamic bank. This type of transaction ensures that the buyer does not need to pay any excess charges and provides an ethical means of acquiring
a property.

The Shariah has identified permissible means for acquiring property and Islamic banks cater to provide the opportunity for individuals to obtain a property whilst adhering to their faith. Islamic banks operate on ethical and socially responsible principles whereby if a buyer cannot afford to pay the monthly rent of the property they are not to be charged additional penalties for late payment, unlike conventional banks which build up interest and increase the customer’s debt.

However, due to the exposure of liquidity risk, Shariah scholars have allowed charging a penalty, which is not considered as a part of the bank’s profit but is a necessary tool, and the money thus generated is distributed to charities. In addition, Islamic banks protect themselves against default, as in the case when a buyer cannot pay an instalment, by asking for strict collateral so that the property, land or products purchased are registered to the name of the buyer from the very beginning of the initial transaction. Islamic banks also have other options to offer its customers, which are similar to real estate leasing. An Islamic bank wishing to offer a loan for a vehicle, for example, may want to use the ijārah wa iqtinā’ contract which allows the bank to sell the product at a higher price than the current market sells it at until the buyer can afford to pay for it.The ownership of the product will remain with the Islamic bank until the product has been fully paid for.

The aim of Islamic banking is not just to serve as a financial institution for its customers but also to promote the principles governed by Islam, which involves ethical investments and moral purchasing of products. Islamic banks and Shariah compliant financial institutions that offer Islamic banking products and services are expected to establish or refer to a Shariah Supervisory Board (SSB). The role of the SSB to Islamic banks and financial institutions is to advise them on their operations and activities of the bank and ensure Shariah compliancy in all forms of product offerings, investments or transactions.The SSB of an Islamic bank or financial institution can only advise and issue the legitimacy of a product or service based on the general consensus of the members of the board or referral to expert scholars. All passing of judgement on potential Islamic products and contracts are decided by the board or authority of the bank and have to refer to the ethical principles of Shariah compliant financing based on the tenets of Islam.

There are a number of Shariah advisory boards and institutions, which are now rapidly emerging to offer Shariah advisory services to Islamic banks and institutions that offer Islamic financial services. The Islamic banking system may not be able to guarantee any fixed rate of return on a deposit made, nor can it guarantee the capital gains due to the risks of losses which would inevitably have to be deducted from the capital of the bank.

This main difference of operations between Islamic banks and conventional banks results in some countries around the world, which comply with conventional laws, being unable to permit Shariah compliant institutions or banks wishing to implement the profit-and-loss scheme, which ensures the operation of Islamic banking. Islamic banks operate with a variety of sources of funds to offer their customers. These sources of funds include current accounts, saving accounts, and investment accounts, and limited, unlimited and specified deposit investments from depositors. Islamic banks do not pay interest on any form of deposits but gain their funds through different approaches altogether. The exclusion of ribā can be noted through all transactions, sources of funds and product offerings that Islamic banks and financial institutions have to offer in operating a fully-fledged Islamic bank.

Many Islamic banks that have been set up in Islamic financial hubs such as Malaysia and the UAE have prospered in offering innovative Shariah compliant products and services. This has led to the popularity and sustained use of the Islamic bank not only for people who want to utilize Islamic banking in adherence to their faith but also for those who find it an ethically beneficial way of managing finances. Some renowned Islamic banks that have seen success in Shariah compliant banking are the Islamic Development Bank, Dubai Islamic Bank, Bank Islam Malaysia Berhad, Meezan Bank and Al-Rajhi, among others.

The global growth of Islamic banks has flourished since their initial emergence in the 1970s, and they can only prosper if Islamic banks operate in a Shariah compliant manner, adhering to the methods of financing laid out by the principles of Islam. Islamic banking continues to provide an ethical alternative to conventional banking, which not only enables Muslims to follow the principles of financing according to their faith but also provides a responsible means of banking for people of all faiths who want to follow an alternative to conventional interest-based financing.

Islamic Finance as a New Paradigm
Islamic finance and banking is growing at an unprecedented rate around the world, and the impact of the Islamic resurgence has played a pivotal role in shaping the growing success of the industry. The objective of this book is to serve as an introduction to Islamic finance and banking with the aim of providing an
invaluable resource that can be utilized by students, professionals and those wishing to learn about Islamic finance from its inception to its future development.

Read the full book 'Islamic Finance: A Practical Introduction' by Tasnim Nazeer

Paperback - 9780860376354 - £9.99