Global Islamic banking industry is estimated at US$ 1 trillion and projected to get doubled in the coming 5 years. Islamic banking is more than non-interest bearing financing, it is an ethical asset-based financial system.
The Islamic banking is an industry of itself governed by set of rules and standards issued by world-class organizations such as the Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI and International Financial Reporting Standard - IFSB. There are key features that recognize the Islamic banking from the conventional banking.
No-interest bearing financing
The taking of interest is strictly prohibited in Islam. This does not mean that capital is costless in Islamic finance, but that returns or profits should be linked to a value creating investment in a good or service.
Uncertainty or “Gharar” is defined as ambiguity in a contractual relationship where the end result can only be zero-sum game, i.e. one party profiting at the expense of another.
Financing or investing in projects that are harmful to people (alcohol or tobacco) or immoral under Islam is prohibited.
Asset-based financial system
The function of money in Islamic banking is to facilitate trade and as a measure of value to goods and services. Unlike conventional financial institutions, money is not considered a tradable commodity in itself.
The prohibition on taking interest has made Islamic financial institutions and finance an asset-based system. Main Islamic banking products i.e. Murabaha, Istisna’a and Ijara involve investment in real assets or services resulting from those assets, and due to prohibitions on Gharar, risk in these transactions is usually shared between the parties. Islamic banks can provide finance using one of more of the following asset-based forms:
Most of Islamic banking transactions are under this form. In Murabaha transactions, the Islamic bank purchases the product to the request of a client, and re-sells the product to the client on a deferred payment basis. The bank purchases the product from the vendor, and sells the product to the customer at a marked up price (P+X), on a deferred payment basis. The period covering the deferred payment is effectively the financing period. The title to the product is transferred to the customer at the time of purchase, but the customer usually provides a collateral to the company during the financing period
The Islamic bank purchases the product and then leases it to the buyer with a profit margin. The customer makes periodic (typically monthly) rental payments to the Islamic bank. The title to the property remains in the finance company’s name
Istisna’a is primarily a deferred delivery sale contract. It can be used for financing the construction of a product. With Istisna’a, the parties meet to agree on the specifications of the construction and the price. The Islamic bank then appoints the contractor to complete the project. The customer only commences repayment only once the project is completed. Repayments can be made at a fixed or a flexible profit rate
The asset is bought by the Islamic bank and resold to the customer in the form of an equity partnership. The customer buys an initial share and with each installment this share increases to eventually reach 100 percent ownership. Profits and losses, if they are part of the operation, are shared between the parties as in any equity agreement
An agreement between a Islamic bank and a third party whereby one party would provide a certain amount of funds, which the other party (Mudarib) would then invest in a specific enterprise or activity against a specific share in the profit. The Mudarib would bear the loss in case of default, negligence or violation of any of the terms and conditions of the Mudaraba
An agreement whereby the Company provides a certain sum of money to an agent, who invests it according to specific conditions in return for a certain fee (a lump sum of money or a percentage of the amount invested). The agent is obliged to return the invested amount in case of default, negligence or violation of any of the terms and conditions of the Wakala
Written by: Bassel Nadim