Principles of Islamic Banking

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INTRODUCTION

The basic concept of Islamic banking which is also known as 'interest-free banking' is based on basic ethical standards with just one main difference- Muslims are not allowed to pay or receive interest. This does not mean that business activities or making a profit are not encouraged, they are but as long as they don’t involve interest in any form. To fulfil this purpose, financial instruments have been introduced by the Islamic financial institutions to satisfy these requirements. An example that can be seen is that equity financing is used instead of debt financing. Furthermore, instead of giving a fixed interest rate on the savings account, Islamic banks offer a share of the bank's profit, as a return on deposits and this is around 5% annually.

HISTORY

The modern banking system was introduced into the Muslim countries in the late 19th century when most of these countries were performing that well economically as well as politically. These banks founded branches in the capital cities of major Muslim countries to cater their business needs. However, the branches were limited to the capital cities and the other surrounding cities were totally ignored by the banking system.

Nevertheless, most local businesses still refrained from engaging with these “commercial” banks, mainly for religious reasons. The reason behind this is that banks operate on the basis of charging interest, a concept totally forbidden by Islam.

As time went by however, it became challenging to avoid commercial banks. They were more efficient in certain banking aspects such as money transfers and current accounts, but borrowing loans and opening saving deposits were still avoided due to the prohibited interest issue.

As the second half of the 20th century has witnessed, any business-related transaction almost always involves a bank and hence, avoiding the modern banking system has become virtually impossible. Banks extended into local communities and thus, forced themselves into almost every kind of business and their related transactions. This is when many Muslim intellectuals recognized the need for an Islamic banking system that will serve the needs of Muslims from the business point of view and at the same time respecting the codes of Islam.

Islamic banking as an institution has been around for 25 years but interest-free banks have also been tried before. ...

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...system yet it has already been implemented many Muslim and a few non-Muslim countries. Despite the successful acceptance there are problems which are mainly in the area of financing.

Islamic banks, however, can eliminate the doubtful forms of financing and offer a clean and efficient interest-free banking. This can be put into effect by making use of only two forms of financing -- loans with a service charge and Mudaraba (or participatory financing) -- both of which are fully accepted by Islam. Such a system will create a competitive advantage where Islamic banks and conventional banks both co-exist. In addition, Islamic banks will have no difficulty in establishing and operating in non-Muslim countries.

Mudaraba is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.

Therefore, Islamic banks have the potential to compete with perhaps even outperform the common commercial banks that are currently available if they follow the Shari’ah rulings and put it in effect.

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