What is Islamic Banking?

The guidance and teachings of Islam, which literally translates as subservience to God, are not just limited to worship. In fact, Islam gives direction for all walks of life; From marriage, travel, eating, socialising to trading. Islamic finance is a manifestation of these core Divine guidelines given to man.

 

Islamic finance refers to financial activities which do not contradict the principles of Shariah (Islamic law). Islamic banking plays a major role in the Islamic finance industry and the overall Islamic economy. Although Islamic banks provide similar functions to conventional banks, the business models, behind the scene processes, contractual arrangements and relationship between the Islamic bank and the customers are different to that of a conventional bank.

 

Conventional banks take deposits from its customers and provides loans to the public. Therefore, the banker‑customer relationship is always a debtor‑creditor relationship in a conventional bank. Thus, the business model of a conventional bank is based on lending with interest (Riba).

 

The giving and receiving of interest has been categorically forbidden in the Islamic faith. Moreover, such transactions have been described as “waging a war with God” in the Quran. It is of no surprise that such strong words have been used to describe interest based transactions. One of the underlying issues with Riba is that it disassociates finance from the real economy and separates debt creation from wealth creation. This divergence causes debt to grow at a higher pace than wealth resulting to an inverted debt pyramid which eventually results in economic instabilities and crises.

 

In Islam, financing and real economic activity cannot be disconnected; wealth creation and debt creation must take place simultaneously. As a consequence, Islamic products must be directly linked to the exchange of goods and services. To be lawful, any profit or benefit should be linked directly to the performance of a real asset and to its associated risk. Furthermore, Islam does not classify money to be a commodity; a premium cannot be charged on borrowed money. Money serves as a medium of exchange. Because money cannot earn money, a link has to be introduced between money and profit as an alternative to interest. As a result, Islamic banking has been primarily involved in trading, leasing and fee‑based transaction as well as investment activities. Those involved in Islamic banking are not in a position to either borrow or lend money for interest. Subsequently, the nature of the Islamic banker‑customer relationship varies according to the different contracts that Islamic banks and their customers enter into. The relationship can be that of agent and principal, depositor and custodian, investor and entrepreneur as well as that characterising fellow partners in a joint investment project.

 

The objective of Islamic banking is not profit maximisation; the objective of the Islamic banking industry should be to facilitate Shariah compliant finance and growth for the society. This ethical revolution will be a means of bringing economic justice, growth and equitable distribution of wealth in the society.