Islamic banking refers to the fundamental financial practices in the light of Islamic sharia law that is based on the concept of social betterment and brotherhood. The partners in a banking transaction are business partners who bear the loss or profit jointly in the eyes of sharia law.
The principles of Islamic or shariah law are derived from the holy book of Muslim, the Qur’an. Since there have never been any changes in the book, the shariah law has always been the same. In Islamic banking all the transactions are completed in the legal code of the sharia law.
These principles are used by the business owners of the Middle East and some Asian countries to this day. In any formal or non-formal financial transactions, the banks in these parts of the world follow these laws.
Paying or charging an interest
The most basic prohibited systems in the Islamic finance are the collection and payment of interest on loans, either by investors or lender. Interest is usury (Riba), and it is strictly prohibited. Islamic financing also encourages sharing of profit and loss by the partners. Let’s discuss some types of Islamic finance.
Musharkah
It is an investment partnership between two parties where capital is provided by both the parties equally and the profit or loss is borne by both or all of them in an agreed proportion. This allows them to be rewarded equally and not be burdened by any losses.
Mudarbah
This investment partnership is between two or more parties where one party invests the capital (or the bank) and the other the entrepreneurship. The profit and loss are shared by both the parties as the pre-agreed ratio.
There is one more type of Mudarbah, a sales contract between a bank and its customers. The customer orders or buys something and it is paid for by the bank. It is repaid in installments of the total price of that product and the profit margin agreed by the parties.
Qard Al Hasnah
Qard Al Hasnah is a type of loan that is free of interest and has a profit-sharing margin and can be repaid in installments. A small and modest fee for services may be charged.
Hawalah
If a customer has some liabilities, the bank can take it from the customer and let that liability mature. After this, the customer pays the bank the fee and takes it back.
Ijarah
Ijarah is the act of leasing equipment to another person to use for an agreed period of time and agreed amount of rental fee. At the end of the lease period, the customer buys that equipment at the agreed price minus the rental fee that is paid already.
Islamic finance is based on two other crucial principles:
- Material finality of the transaction
Each transaction must be related to a real underlying economic transaction and gambling is not allowed
- Profit/loss sharing
Parties entering the contracts in Islamic finance share all profits, losses, and risks associated with the transaction. No one can benefit more than the other party.
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