Understanding Islamic Banking

What is Islamic Banking?

Islamic banking is a system of conducting banking activities in line with the principles of Shariah while avoiding all the prohibited activities such as
Interest/Riba, Gharar* (uncertainty), dealing in prohibited businesses (e.g. alcohol, gambling), etc.
‘Interest free banking’ is one of the key principles of Islamic banking. It allows you to avoid interest-based transactions, but in addition, also avoid unethical and socially unacceptable practices prohibited under in Shariah, including: unfair trade practices, hoarding, speculation…etc.

Therefore, Islamic banking transactions are based on ‘tangible assets and real services’ as opposed to ‘conventional money lending’

* Gharar: The uncertainty that is present in the basic elements of an agreement (i.e. wording of the agreement, subject matter, etc.)

Is Islamic banking meant only for Muslims?

The teachings of Islam are meant for both Muslims and non-Muslims. Universal values like honesty, justice, avoiding fraud, etc., form the basic principles of Islamic banking. Therefore, Islamic banking is for everyone irrespective of what religion they follow.

What is meant by Shariah?

Shariah means a “Way” or “Path”. In Islam, Shariah means guidance and laws given by the Holy Quran and the Hadith/Sunnah of the Holy Prophet (Peace Be Upon Him). It also includes juristic interpretations of Islamic scholars. Islamic Shariah is derived from the following four sources:

  1. The Holy Quran
  2. The Sunnah of the Holy Prophet (Peace Be Upon Him)
  3. Ijma’ (consensus of the Mujtahideen - ‘Independent Jurists’)
  4. Qiyas (Analogy)
What is Riba or Interest?

"Riba" means excess, increase or addition. As per Hadith of the Holy Prophet (Peace Be Upon Him), “Every loan that derives a benefit (to the lender) is Riba”. Therefore, interest means giving and/or taking of any excess amount in exchange of a loan or on debt. Hence, it has the same meaning as that of Riba.

Are Islamic banks not just paying interest and dressing it as profit on trade and investments?

This is not the case. Islamic banks accept deposits from customers on profit and loss sharing or on the basis of “Qard”. These funds are used in Shariah compliant modes of finance, trade or investment. The income generated by these Shariah compliant modes are then distributed among the depositors as profit

The main differentiating points between conventional banking and Islamic banking are:
1 Money is a commodity as well as a medium
of exchange. Therefore, it can be sold at a
price higher than its face value and it can
also be rented out.
Money is not a commodity. It is only used as a
medium of exchange. Therefore, it cannot be sold
at a price higher than its face value or rented out
2 Profit is earned by charging interest on
capital. ‘Time value’ is the basis for charging
interest on money/capital.
Profit is earned through trade of goods
.or charging for providing services.
3 Interest is charged even in case the
organisation suffers losses by using the
bank’s funds. Therefore, it is not based on
profit and loss sharing.
Islamic banks may operate on the basis of profit
and loss sharing. If the business has suffered
losses, the bank will share these losses based on
the mode of finance used (e.g. Mudarabah and Musharakah).
4 While disbursing cash finance, running
finance or working capital finance, no
agreement for exchange of goods and
services is made.
The execution of agreements for the exchange of
services is a must while disbursing funds under
Murabaha, Salam and Istisna contracts
5 Conventional banks use money as
a commodity which leads to inflation.
Islamic banking tends to create link with the real
sectors of the economic system by using trade
related activities. Since money is linked with real
assets, it contributes directly to economic

Shariah Compliant Modes of Banking & Finance

Investment / Participatory Modes


Mudarabah is an arrangement in which a person (called Rab-ul-Mal) participates with his money and another person (called Mudarib) participates with his efforts. The parties agree, at the beginning, on a profit sharing ratio between them


Musharakah is a partnership contract. The profits are shared as per agreed ratios between partners and losses are borne in proportion to their respective capital contributions.

Diminishing Musharakah:

Diminishing Musharakah (DM) is a form of co-ownership in which two or more persons share the joint ownership of a tangible asset (e.g. house) in an agreed proportion. It is agreed that one of the co-owners will purchase, in periodic instalments, the share of the other co-owner until the ownership of that tangible asset is completely transferred to the purchasing co-owner. Furthermore, along with the purchase of share, the (purchasing) co-owner will also make periodic payments for the usage of other co-owner’s share in the asset.

Trading / Sales Modes


Murabaha means sale of goods where the seller is obliged to disclose to the buyer the cost of goods sold. The sale could either be on cash or on a deferred payment basis. The parties agree on the cost of goods sold and the profit margin included in the selling price.


Musawamah is the general sale of goods whereby the seller is not obliged to disclose to the buyer the cost of goods sold.


Salam is a sale transaction in which the seller agrees to supply specific goods to the buyer at a future date against an advance payment which is fully paid at spot. The basic purpose of Salam is to meet he needs of the small farmers for the production of agricultural products.


Istisna is a sale transaction where a commodity is transacted before it comes into existence. In Istisna, the buyer is given an order to manufacture a specific commodity. Following are necessary conditions for Istisna:

  • Price is fixed with the consent of parties.
  • The specification of the commodity to be manufactured must be agreed between parties.


Ijarah is a type of rental contract whereby the owner of an asset (e.g. car), transfers the right to use to another person for an agreed period and price

Fee / Service Modes


Wakalah is an agency contract in which one person appoints another person as his agent to perform a certain task on his behalf on agreed terms and conditions, usually against a certain fee. A contract of Wakalah can take place only in respect of such acts which the principal is competent to perform himself, provided such act can be performed by the agent.


Kafalah is a contract in which a third party becomes surety i.e. provides guarantee for the payment of debt on behalf of the debtor. It is a pledge given by a third party to a creditor to the effect that if the debtor defaults in payment of the debt, it will be paid by said third party as Kafeel or guarantor

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