Introduction to Islamic Banking: A Basic Concept

» Islamic Banking: Introduction

Islam has given an immense importance to trade. The nobility of this profession is obvious
from the fact that it was the chosen profession of prophet Muhammad (PBUH). Islam is a
complete code of life that provides guidance regarding each aspect of life. The primary
objectives of Islamic economic system are: equal distribution of wealth and social justice.
Islamic finance is a term that reflects financial business that is not contradictory to the
principles of Shari’ah.
Conventional finance, particularly conventional banking business, relies on taking deposits
from and providing loans to the public. A key aspect of conventional banking is the giving or
receiving of interest, which is specifically prohibited by Shari’ah.

» The Components of Islamic Finance

(1) Banking and interest (Riba):
The relationship of the Islamic bank with the suppliers of funds can be of agent and
principal, depositor and custodian, investor and entrepreneur as well as between fellow
partners in a joint investment project.
Similarly, the relationship of the bank with the users of funds can comprise of vendor and
purchaser, investor and entrepreneur, principal and agent, lessor and lessee, transferor and
transferee and between partners in a business venture.
This is in sharp contrast to that of conventional banking, which is simply a lender-borrower
relationship.
(2) Takaful – Islamic insurance:
With regards to Islamic insurance, better known as Takaful, the insurer, that is the
insurance company, is prohibited from providing indemnity to the insured, that is, the
policyholders, as this is not acceptable to Shari’ah principles. Takaful introduces the
contract of donation among the participants/policyholders as a substitute for the contract
of sale of indemnity for a premium as practiced in conventional insurance.
(3) Islamic capital markets:
Islamic capital markets that consist of both equity investments and fixed income
instruments must avoid some conventional elements and principles from both contractual
and transactional perspectives. In addition to interest and uncertainty, issues such as
gambling, which is a zero-sum game, investments in unlawful activities and capital
guarantee elements in equity-based products are to be avoided.

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» Differences between Conventional Financing and Islamic Financing

Conventional finance Islamic finance

(01)Primarily is based on interest rate. (01)Interest is prohibited.
(02)Facilitate financial activities. (02)Facilitate social, economic and financial
activities.
(03)Structured and formalized. (03)Unstructured and still informal in many
ways.
(04)Stress on financial efficiency. (04)Stress on social, ethical and financial
efficiency.
(05)Restricted moral dimension. (05)Strong moral dimension.
(06)Highly systematized in terms of risk (06)Standards for risk management,
management, accounting and other accounting and other activities are still
standards. developing.
(07)Existing set of legislation to deal with (07)Legal support still in development with
legal issues. several legal areas under doubt.
(08)Highly developed banking and financial (08)Developing banking and financial
product market. product market.
(09)Existence of conventional money (09)Non-existence of significant islamic
market. money market.
(10)Availability of inter-bank funds. (10)Non-availability of inter-bank funds.
(11)Strong and developed secondary (11)Non-existing secondary market for
market for securities. securities.
(12)Existence of short-term money market. (12)Non-existence of short-term money
market.

» Riba and Interest

The Holy Quran has prohibited riba. What is meant by this term?
The word “riba” as a noun literally means in Arabic, an increase and as a root, it means the
process of increasing. Riba has been understood throughout Muslim history as being
equivalent to interest paid on a loan. Shari’ah scholars have used the term riba in three
senses; one basic and two subsidiary.
In its basic meaning, riba can be defined as “anything (big or small), pecuniary or
non-pecuniary, in excess of the principal in a loan that must be paid by the borrower to the
lender along with the principal as a condition (stipulated or by custom) of the loan or for an
extension in its maturity.” This is called riba al-qard or riba al-nasa.
The two subsidiary meanings of riba relate to such transactions and fall into the category of
riba al-buyū (riba on sales).
The first of these is riba al-nasī’ah, which stands for the increase in lieu of delay or
postponement of payment.
The second is ribā al-fadl, which relates to the purchase and sale of commodities.
In this context, ribā al-fadl refers to the excess taken by one of the trading parties while
trading in any of the six commodities mentioned in a well-known authentic hadith.
Abū Said al Khudrī (was one of the youngest Companions of the Prophet (s)) narrated that
the six commodities are:

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“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt
for salt. If anyone gives more or asks for more, he has dealt in riba. The receiver and giver
are equally guilty” (Muslim).

Of the six commodities specified in the hadith, two (gold and silver) unmistakably represent
commodity money used at that time. One of the basic characteristics of gold and silver is
that they are monetary commodities. As a matter of fact, each of the six commodities
mentioned in the hadith has been used as a medium of exchange at some time or the other.
Hence, it has been generally concluded that all commodities used as money enter the
sweep of riba al-fadl. The other four commodities specified in the hadith represent staple
food items. So, definition of ribā, anything, big or small, stipulated in the contract of loan to
be paid in addition to the principal is ribā. Such additional payment in modern terminology
is known as interest. Thus riba and interest rate are the same.

» What is the scope of transactions to which the ban on riba is applicable? Does the term
apply only to the interest charged on consumption loans or does it also cover productive
loans advanced by banking and financial institutions?
The prohibition of ribā al-nasī’ah essentially implies that fixing in advance a positive return
on a loan as a reward for waiting is not permitted by the Shari’ah. In this sense, ribā has the
same meaning and import as the contemporary concept of interest in accordance with the
consensus of all fuqahā’ (jurists).
It makes no difference whether the loan is for consumption or business purposes and
whether the loan is given (or taken) by a commercial bank, government, corporation or an
individual.

» Does the prohibition of riba apply equally to the loans obtained from or extended to
muslims as well as non-muslims?
The Islamic Fiqh Academy mentioned above does not recognize any distinction between
Muslims and non-Muslims, or between individuals and states with respect to the receipt
and payment of interest. Resolutions of the Islamic Fiqh Academy are considered to reflect
the consensus of fuqahā’ at the present time. Therefore, the prohibition of ribā has
universal application.

» The value of paper currency depreciates in inflationary situations. In order to

compensate lenders for the erosion in the value of their principal, a scheme of
“indexation” has been suggested. Is such a scheme acceptable from an islamic point of
view?
Once a country is caught in the mess of inflation, the question of a possible resort to
indexation arises. The Shari’ah aspect of indexation in such exceptional situations is still
under consideration by the fuqahā’, especially the OIC Fiqh Academy. While the Academy
has so far allowed indexation in the case of wages and contracts fulfilled over a period of
time, provided that this does not harm the economy, it has not allowed it in the case of
monetary debts. Meanwhile, it allows the creditor and the debtor to agree on the day of
settlement – but not before – to settle the debt in a currency other than the one specified
for the debt, provided that the rate of exchange applied is the one that prevails on the
settlement date.

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