Islamic Banking – Definition

Cite this article as:"Islamic Banking – Definition," in The Business Professor, updated January 10, 2020, last accessed October 27, 2020,


Islamic Banking Definition

Islamic Banking refers to a system of financial management that is guided by the principles of Islamic rules. Banking in Islam is a framework of saving money governed by Islamic law standards, also known as the Sharia law. The two fundamental concepts of Islamic banking is the prohibition of interest (riba) collection and payment and profit and loss sharing. In other words, Islamic law does not allow gathering and interest collection.

A Little More on What is Islamic Banking

Banking is a concept that exists in different shapes and forms in society. There are various systems of banking across the globe. However, the most popular types of banking are conventional and Islamic banking.

Regular banking operations involve borrowing money from customer deposits and lending it to make profits. The Islamic banking system works differently. The system is under the guidance of the service partnership principle, where the shareholders, borrowers, and depositors all take part in the sharing of profits and losses.

What is important to note about Islamic banking is that it operates under Sharia law, and all bank operations must operate under those Islamic principles. Islamic banking has financial transaction rules known as Fiqh al-Muamalat, which is culturally different from ethical investing.

For instance, investing in things such as gambling, alcohol, pork, among other forbidden items is not allowed. Islamic banking is widespread. More than 300 Islamic banks are operating in over 51 countries, the United States inclusive.

Islamic Banking History

Islamic Banking can be dated back to the early seventh century, when Khadija, the first wife to prophet Mohammed, was a merchant. The prophet operated as an agent for his wife’s business, where he applied the same principles that the current Islamic banking practice.

During the middle ages, business activities in the world of Muslims depended on the principles of Islamic banking. The principles later spread across many regions, including Mediterranean, Spain, and Baltic states offering several bases for policies in western banking. From the early 1960s to 1970s, Islamic banking reemerged in the contemporary world.

How Islamic Banking Works

To be able to know how Islamic banking works, first you must understand the rules involved in Islamic banking. The majority of Sharia scholars agree that a commodity’s credit price can exceed its cash price. So, the Islamic Fiqh Academy of Sharia Board and IOC of all Islamic banks, support the legality of this difference. Nevertheless, once there is mutual agreement about the price, no addition to the price is allowed.

The main goal that Islamic banking strives to achieve is procuring money without imposing premium charges on the principal amount. Islamic banks make use of value support frameworks to realize this. The credit cash to a business and the business repays the advance without any premium.

 Principles of Islamic Banking and Finances

The principles of Islamic banking operate under Sharia Law, founded on the Quran and Hadith. These are the recordings of the actions and sayings of the prophet Mohammed. So, the bankers ensure that the banking activities do not deviate from the Quran’s fundamental principles. The principles are as follows:

  • Non-payment of interest

According to Islam teachings, lending money with interest payment is exploiting the borrower and favoring the lender. So, the Sheria law does not allow interest payment, also known as riba.

  • Investing in Businesses Involved in forbidden Activities

Islam teachings consider business activities such as alcohol and pork selling as haram (forbidden). Investing in these types of businesses will be going against the Sharia law. The law, therefore, prohibits Islam believers from investing in these types of business activities.

Sharia law forbids any form of gambling or assumption, which they refer to as maisir. It means that Islamic financial institutions are not allowed to be part of contracts whose owners depend on uncertain future events.

  • Risk and Uncertainty (Gharar)

According to the rules of Islamic finance, participating in contracts with extreme uncertainty and risk is prohibited. Muslims refer to this as gharar. The term gharar assesses the legitimacy of uncertain or threat when it comes to nature investments. The use of Gharar applies to short-selling and derivative contracts that Islamic finance prohibits.

Types of Islamic Financing Arrangement

Note that Islamic finance is based on several principles and restrictions that is non-existence in conventional banking. For this reason, there are several special financial arrangements developed that comply with some of its policies. They are as follows:

  • Profit and Loss Sharing Partnership (Mudarabah)

Profit and loss sharing partnership, also known as Mudarabah is an arrangement where the financier (Rab-ul mal) gives capital to a labor provider (mudarib). Mudarib has the responsibility of managing and investing the money. The two parties then share profits from this investment as per the initial ratio agreement.

  • Profit and Loss Sharing Partnership (Mudarabah)

Musharaka is where all parties in the business venture contribute capital and also share profits and losses on an equal basis. Examples of such joint ventures include:

Diminishing partnership: It is a type of joint venture that partners use to acquire properties. In this method, both the bank and investors come together to purchase properties. They will then gradually transfer its part of the equity in the pr interested investors in exchange for money.

Permanent musharkah: Investors use this type of joint venture to finance long-term investment projects. It is termed as continuous because the joint venture does not have an end date. Instead, it operates continuously as long as the parties involved agree to continue working together.

  • Leasing (Ijarah)

Renting, also is known as ijarah, is a type of arrangement where the owner of the property (leaser) leases the property to the lessee. The leaser will then receive a stream of purchase and rental payments in return. The process ends with the property ownership transfer to the lessee.

Islamic Banking Advantages

Islamic finance offers several benefits. They include the following:

  • It ensures financial inclusion. What this means is that businesses as well individuals can access affordable and useful financial services and products to help meet their needs. It delivers payments, transactions, credit, insurance, and savings sustainably and responsibly.

Note that although receipt and payment of interest (riba) are not allowed under Islamic Law, Islamic banking still ensures financial inclusion that promotes savings in the large pool both in the global and local economy.

  • Islamic banking reduces the impact resulting from harmful products and practices. Remember that Sharia law does not allow any transaction that promotes activities and industries that Islam teachings forbid.
  • Islamic banking ensures justice through its principle of sharing loss and profits, including any other risk that comes up. So, the law makes sure that Islamic finance products are Sharia-compliant, where it ensures that kes sure profits, losses, and threats are proportionally shared.

The situation is different from the western financial system, whose aim is to make profits by charging interest on the principal amount it lends customers. In this type of banking, it is the customers who are liable for the risk.

  • Islamic banking encourages stability as far as investment is concerned. In this type of banking, the investment approach is through a slower and insightful decision-making process.

For those companies whose financial operations and practices appear to carry many risks, Islamic commercial companies usually avoid them. However, through intensive analyses and audits, Islamic finance can reduce the risk, creating space for a stable and more excellent investment.

  • Islamic banking accelerates the development of the economy. Note that Islamic financial institutions have objectives of ensuring that they grow and, at the same time, make profits. So, the choice of investing in a particular business will depend on the success and potential growth of these businesses.

With Islamic banks, each bank strives to invest in business ventures that will give them better returns. They also try hard to out-perform their rival banks so that they can attract more depositors and funds. This move results in high profits on investments both for depositors and the banks.

References for “Islamic Banking › Islamic Finance Blog

Was this article helpful?