What Is Islamic Banking?

Islamic banking, also referred to as Islamic finance or shariah-compliant finance, refers to financial activities that adhere to shariah (Islamic law). 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.

Key Takeaways

  • Islamic banking, also referred to as Islamic finance or shariah-compliant finance, refers to finance or banking activities that adhere to shariah (Islamic law).
  • 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 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 conventional banks have windows or sections that provide designated Islamic banking services to their customers.

Understanding Islamic Banking

There are approximately 520 banks and 1700 mutual funds around the world that comply with Islamic principles. Between 2012 and 2019, Islamic financial assets grew from $1.7 trillion to $2.8 trillion and are projected to grow to nearly $3.7 trillion by 2024, according to a 2020 report by the Islamic Corporation for the Development of Private Sector (ICD) and Refinitiv. This growth is largely due to the rising economies of Muslim countries (especially those that have benefited from the increases in the price of oil).

10%

The anticipated growth in the global Islamic finance industry over 2021-22, due to increased bond issuance and a continuing economic recovery in the financial markets, according to S&P Global Ratings. Islamic assets did manage to expand over 10% in 2020, despite the COVID-19 pandemic.

Islamic banking is grounded in the tenets of the Islamic faith as they relate to commercial transactions. The principles of Islamic banking are derived from the Qur'an–the central religious text of Islam. In Islamic banking, all transactions must be compliant with shariah, the legal code of Islam (based on the teachings of the Qur'an). The rules that govern commercial transactions in Islamic banking are referred to as fiqh al-muamalat.

Employees of institutions that abide by Islamic banking are entrusted with not deviating from the fundamental principles of the Qur'an while they are conducting business. When more information or guidance is necessary, Islamic bankers turn to learned scholars or use independent reasoning based on scholarship and customary practices.

One of the primary differences between conventional banking systems and Islamic banking is that Islamic banking prohibits usury and speculation. Shariah strictly prohibits any form of speculation or gambling, which is referred to as maisir. Shariah also prohibits taking interest on loans. In addition, any investments involving items or substances that are prohibited in the Qur'an—including alcohol, gambling, pork—are also prohibited. In this way, Islamic banking can be considered a culturally distinct form of ethical investing. 

To earn money without the typical practice 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. In general, Islamic banking institutions tend to be more risk-averse in their investment practices. As a result, they typically avoid business that could be associated with economic bubbles.

While an Islamic bank is one that is entirely operated using Islamic principles, an Islamic window refers to services that are based on Islamic principles that are provided by a conventional bank. Some commercial banks offer Islamic banking services through dedicated windows or sections.

History of Islamic Banking

The practices of Islamic banking are usually traced back to businesspeople in the Middle East who started engaging in financial transactions with their European counterparts during the Medieval era. At first, they used the same financial principles as the Europeans. However, over time, as trading systems developed and European countries started establishing local branches of their banks in the Middle East, some of these banks adopted the local customs of the region where they were newly established, primarily no-interest financial systems that worked on a profit and loss sharing method. By adopting these practices, these European banks could also serve the needs of local business people who were Muslim.

Beginning in the 1960s, Islamic banking resurfaced in the modern world, and since 1975, many new interest-free banks have opened. While the majority of these institutions were founded in Muslim countries, Islamic banks also opened in Western Europe during the early 1980s. In addition, national interest-free banking systems have been developed by the governments of Iran, Sudan, and (to a lesser extent) Pakistan.

Example of Islamic Banking

The Mit-Ghamr Savings Bank, established in 1963 in Egypt, is commonly referred to as the first example of Islamic banking in the modern world. When Mit Ghamr loaned money to businesses, it did so on a profit-sharing model. The Mit-Ghamr project was closed in 1967 due to political factors but during its year of operations the bank exercised a great deal of caution, only approved about 40% of its business loan applications. However, in economically good times, the bank's default ratio was said to be zero.

What Is the Basis of Islamic Banking?

Islamic banking is grounded in the tenets of the Islamic faith as they relate to commercial transactions. The principles of Islamic banking are derived from the Qur'an–the central religious text of Islam. In Islamic banking, all transactions must be compliant with shariah, the legal code of Islam (based on the teachings of the Qur'an). The rules that govern commercial transactions in Islamic banking are referred to as fiqh al-muamalat.

What Are the Differences Between Conventional and Islamic Banking?

One of the primary differences between conventional banking systems and Islamic banking is that Islamic banking prohibits usury and speculation. Shariah strictly prohibits any form of speculation or gambling, which is referred to as maisir. Shariah also prohibits taking interest on loans. Also, any investments involving items or substances that are prohibited in the Qur'an—including alcohol, gambling, and pork—are also prohibited. In this way, Islamic banking can be considered a culturally distinct form of ethical investing.

How Do Islamic Banks Make Money?

To earn money without the typical practice of charging interest, Islamic banks use equity participation systems, which is similar to profit sharing. 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.