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Islamic banking – How does it work?
Islamic finance is now booming around the world. But how does it work and how is Islamic banking different from conventional banking?
July 29, 2013 1:47 by kippreport
The basic principle of Islamic banking is based on risk sharing, which is a component of trade rather than risk-transfer, which is also seen in conventional banking. This is because Sharia Islamic law prohibits any investment from paying interest, as making money from money itself is considered sinful.
Islamic banking is a growing series of financial products developed to allow Muslims to invest and raise finance in a way that does not compromise their religious or ethical beliefs.
Sharia law also bans investment in certain industries, such as tobacco, alcohol, gambling or firearms, which are considered as ‘haram’.
However, both Muslims and non-Muslims can take advantage of Islamic banking products.
The history of Islamic finance
Although the industry is quite young, Islamic economic theories date back more than a millennium. By the middle of the 12th century, many Muslim scholars had already presented several key concepts that are relevant even today.
However, social and political turmoil put those concepts on hold for many centuries and it was only in the 20th century that Muslim academics and scholars revisited them. By doing so, they set the stage for the modern Islamic finance industry, and it began to emerge in the 1970s.
How does it work?
Islamic banking offers the same elements as conventional banking – capital markets, fund managers, investment firms and insurance companies, as well as personal finance products, such as credit cards, car finance, personal finance and home finance.
As mentioned before, the key principle to remember with the Islamic finance model is that all forms of interest (riba) are forbidden. Instead, the customer and the bank share the risk of any investment and divide any profits between them.
It is for this reason that when you see an Islamic banking product; it will talk about the profit rate, rather than an interest rate. This principle forms the basis of how Islamic banking products are designed and they are all based on specific types of contract. These include:
Ijara: This is a leasing agreement, where the bank buys an item for a customer and then leases it back over a specific period of time. This could be applied to a car loan, a mortgage or a personal loan.
Ijara-wa-Iqtina: A similar arrangement to the Ijara, where the customer leases the item (for example, a car or house) and eventually buys the item back at the end of the period at an agreed lease amount and purchase price. Again, this could be applied to different types of loan.
Mudaraba: The term refers to a form of business contract in which one party brings capital and the other puts in personal efforts. The proportionate share in profit is determined by mutual agreement. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour.
Murabaha: In this arrangement, the bank will buy an item and then sell it on to the customer on a deferred basis. This is typically used for personal loans. Banks will also buy commodities or stocks and then sell them back to the client at a profit.
To give you an idea of how it works, a bank that offers goods (murabaha) and services (ijarah) loans will buy the service (like wedding services, travel services, medical treatment, house rent or education) or goods (for example, furniture, electronics, computers, motorbikes, home renovation) directly from the provider and then resell it to you.
While there are numerous personal finance products available in the UAE and Saudi Arabia – there are both, conventional and Islamic banking options for each so make sure you only search for the latter when you are comparing. You can search and compare all the personal finance options, which are Sharia Compliant in the UAE, as well as the Islamic banking options in Saudi Arabia.
There are banks, such as ADIB in the UAE, for example, who offer a personal finance product for customers, as well as the UAE Nationals who want to invest in shares in the UAE exchanges. It comes with a reducing rate or profit rate of 18 per cent, however there is also a 1 per cent processing fee to consider.
Similarly, in Saudi Arabia, Banque Saudi Fransi offers a personal finance product for Saudi residents at a reducing profit rate of 2.9 per cent based on the Murabaha principal (see above for explanation), with an upfront fee of SR1, 600.
Before making any choices, remember to check the entire processing and admin fees associated with the product.
Ambareen Musa is the founder and CEO of Souqalmal.com. Having moved to the Middle East in 2008, Ambareen worked as a consultant for Bain & Company – Middle East and focused on the financial services sector, before joining MasterCard Middle East and Africa to set up their consulting arm, before leaving two years later to become the founder of Souqalmal.com in 2011.