What is 'Islamic Banking'

Islamic banking is a banking system that is based on the principles of Islamic law, also referred to as Shariah law, and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest by lenders and investors. Collecting interest or "riga" is not permitted under Islamic law.

BREAKING DOWN 'Islamic Banking'

Since this system of banking is grounded in Islamic principles, all the undertakings of the banks follow Islamic morals. Therefore, it could be said that financial transactions within Islamic banking are a culturally distinct form of ethical investing. For example, investments involving alcohol, gambling, pork, etc. are prohibited.

How Are the Principles of Islamic Banking Determined?

The principles of Islamic Banking follow Shariah law, which is based on the Quran and the Hadith, the recorded sayings and actions of the Prophet Muhammad. When more information or guidance is necessary, Islamic bankers turn to learned scholars or use independent reasoning based on scholarship and customs, while also ensuring their ideas do not deviate from the fundamental principles of the Quran.

What Is the History of Islamic Banking?

The origin of Islamic banking dates back to the very beginning of Islam in the seventh century. The prophet Muhammad's first wife, Khadija, was a merchant, and he acted as an agent for her business, using many of the same principles used in contemporary Islamic banking. In the Middle Ages, trade and business activity in the Muslim world relied on Islamic banking principles, and these ideas spread throughout Spain, the Mediterranean and the Baltic States, arguably providing some of the basis for western banking principles. In the 1960s to the 1970s, Islamic banking resurfaced in the modern world.

How Do Islamic Banks Earn Money Without Using Interest?

In order to earn money without charging interest, Islamic banks use equity-participation systems. This means that if a bank loans money to a business, the business pays back the loan without interest, but it gives the bank a share in its profits. If the business defaults on the loan or does not earn any profits, the bank does not receive any profit either.

For example, in 1963, Egyptians formed an Islamic bank in Mit Ghmar. When the bank loaned money to businesses, it did so on a profit-sharing model. To reduce risk, the bank only approved about 40% of its business loan applications, but the default ratio was zero.

What Is the Difference Between Islamic Banks and Islamic Windows?

While an Islamic bank is a bank totally based on and run with Islamic principles in mind, an Islamic window refers to services provided by conventional banks but based on Islamic principles. For example, in Oman, there are two full-fledged Islamic banks, Bank Nizwa and Al Izz Islamic Bank, but six of the seven commercial banks in the country also offer Islamic banking services through dedicated windows.

RELATED TERMS
  1. Accounting and Auditing Organization ...

    A not-for-profit organization that was established to maintain ...
  2. Murabaha

    An Islamic financing structure, where an intermediary buys a ...
  3. Takaful

    A type of Islamic insurance, where members contribute money into ...
  4. Riba

    A concept in Islamic banking that refers to charged interest. ...
  5. Shirkah

    An Islamic finance term that describes a partnership between ...
  6. Musharakah

    A joint enterprise or partnership structure with profit/loss ...
Related Articles
  1. Financial Advisor

    Working With Islamic Finance

    There is no division between the spiritual and the secular in this type of socially responsible investing.
  2. Investing

    How The Islamic State (IS) Got Its Start

    Despite its relatively new emergence in radical Islamist terrorism, the Islamic State, or ISIS, has been around for nearly 12 years.
  3. Insights

    If Trump Had His Way: The U.S. GDP Minus Muslims

    Banning the entry of Muslims into the U.S. could negatively impact its tourism and investment sectors, as well as certain parts of the private sector.
  4. Tech

    Wahed Invest: A Look at the New Islamic Robo-Advisor

    For religious Muslims governed by Sharia, Wahed Invest Inc. is likely a welcome platform in the robo-advisor environment.
  5. Investing

    What are Accounting Principles?

    The term accounting principles refers to rules and guidelines companies use to help them record their business and financial transactions.
  6. Insights

    The Role of Commercial Banks in the Economy

    We interact with commercial banks daily to carry out simple financial tasks. That said, the function and creation of a commercial bank is anything but simple.
RELATED FAQS
  1. What is an Islamic investment policy?

    Islamic investments are a unique form of socially responsible investments because Islam makes no division between the spiritual ... Read Answer >>
  2. Can I match a fund to my religion?

    Specialized mutual funds offer investments tailored for particular religions including Judeo-Christian faiths and Islam. ... Read Answer >>
  3. What is the average profit margin for a company in the banking sector?

    Learn what the average profit margin is for companies in the banking sector, along with other evaluation metrics often used ... Read Answer >>
  4. What's the difference between investment banks and commercial banks?

    Understand the principal differences between investment banks and commercial banks, and the areas of banking services that ... Read Answer >>
  5. How does investment banking differ from commercial banking?

    Discover how investment banking differs from commercial banking, the responsibilities of each and how the two can be combined ... Read Answer >>
Hot Definitions
  1. Five Cs Of Credit

    A method used by lenders to determine the credit worthiness of potential borrowers. The system weighs five characteristics ...
  2. Straddle

    An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration ...
  3. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  4. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  5. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  6. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
Trading Center