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.

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