What Is Islamic Banking?

Islamic banking, also known as non-interest banking, is a banking system that is based on the principles of Islamic or Sharia law and guided by Islamic economics. Two fundamental principles of Islamic banking are the sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors. Islamic law prohibits collecting interest or "riba."

Key Takeaways

  • Islamic banking, also known as non-interest banking, is a system based on the principles of Islamic or Sharia law and guided by Islamic economics.
  • Islamic banks make a profit through equity participation which requires a borrower to give the bank a share in their profits rather than paying interest.
  • Some commercial banks have windows or sections that provide Islamic banking services to customers.

Understanding Islamic Banking

Islamic banking is grounded in Sharia, or Islamic, principles and all bank undertakings follow those Islamic morals. Islamic rules on transactions are called Fiqh al-Muamalat. Typically, financial transactions within Islamic banking are a culturally distinct form of ethical investing. For example, investments involving alcohol, gambling, pork, and other forbidden items is prohibited. There are over 300 Islamic banks in over 51 countries, including the United States.

Principles of Islamic Banking

The principles of Islamic banking follow Sharia 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. The bankers also ensure their ideas do not deviate from the fundamental principles of the Quran.

Two fundamental principles of Islamic banking are the sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors.

History of Islamic Banking

The origin of Islamic banking dates back to the beginning of Islam in the seventh century. The Prophet Muhammad's first wife, Khadija, was a merchant. 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. These banking principles spread throughout Spain, the Mediterranean, and the Baltic states, arguably providing some of the basis for western banking principles. From the 1960s to the 1970s, Islamic banking resurfaced in the modern world.

505

The number of Islamic banks in 2017, according to a report on global Islamic finance.

How Islamic Banks Make a Profit

To earn money without the use of charging interest, Islamic banks use equity participation systems. Equity participation means if a bank loans money to a business, the business will pay back the loan without interest, but instead gives the bank a share in its profits. If the business defaults or does not earn a profit, then the bank also does not benefit.

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 its risk, the bank only approved about 40% of its business loan applications, but the default ratio was zero.

Islamic Banks Versus Islamic Windows

While an Islamic bank is one based on and managed with Islamic principles, an Islamic window refers to the services provided by a conventional bank but based on Islamic principles. For example, in Oman, there are two Islamic banks, Bank Nizwa and Al Izz Islamic Bank. Six of the seven commercial banks in the country also offer Islamic banking services through dedicated windows or sections.