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Ae all you need to know

Islamic Banking – all you need to know

Through this content, we will learn more about Islamic banking, the banking system that complies with Shariah laws and how it differs from conventional banking.

Are you familiar with the principles of Islamic banking, its differentiators and terminology?

At Standard Chartered, we’re committed to providing you with the right financial tips and tools. Through this edition of our educational series, “Basics of Banking”, we shall be skimming the surface of this vast topic.

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 just one of the pillars of Islamic banking. Islamic banking means not only to avoid interest-based transactions, but also to avoid unethical and socially unacceptable practices prohibited in Shariah, such as unfair trade practices, hoarding, speculation, etc. Hence, Islamic banking transactions are based on ‘tangible assets and real services’ as opposed to ‘conventional money lending’.
The teachings of Islam are meant for both Muslims and non-Muslims. Universal values like honesty, justice, avoiding fraud, etc., form the 2 basic principles of Islamic banking. Therefore, Islamic banking is for everyone irrespective of what religion they follow.

How is Islamic banking different from conventional banking?

The end result of Islamic banking and conventional banking may look similar. However, the process and sequence of activities performed to achieve the end goal through Islamic banking are in accordance with the rules of Islamic Shariah.

Here are some key differentiators:

CONVENTIONAL BANKING ISLAMIC BANKING
• 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.
• 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 by providing services.
• 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).
• 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 underlying goods or services is mandatory while disbursing funds under Murabaha, Salam or Istisna contracts.
• Conventional banks use money as a commodity which leads to inflation. • Islamic banking tends to create a link with the real sectors of the economic system by using trade related activities.

Islamic concepts and what they mean

Islamic legal contracts form the basis of various banking products, ensuring that they are Halal/ permissible, and in line with Islamic beliefs and values. Here are some of these concepts:

Qard

A contract of loan between two parties in which the borrower is required to pay back only the principal amount borrowed. The bank must return the money to the depositors when they ask for it.

Mudarabah

A special kind of partnership where one party gives money (Rab-ul-Mal /investor) to another party (Mudarib /working partner) for investing it in a business. The investor cannot participate in management of the business. The parties agree, at the beginning, on a profit sharing ratio between them.

Ujrah

A fee or financial payment for the utilisation of services.

Musharakah

A partnership contract in which the profits are shared as per agreed ratios between partners and losses are borne in proportion to their respective capital contributions.

Diminishing Musharakah

A form of co-ownership in which two or more persons share the joint ownership of an 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.

Murabaha

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

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

Salam

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 the needs of the small farmers for the production of agricultural products.

Istisna

A manufacturing contract where the buyer gives an order to a manufacturer to manufacture a specific product at an agreed price. .

Ijarah

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.

Wakalah

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.

Kafalah

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.

Who guides the Bank on matters related to compliance with Shariah?

The Bank is supervised by an independent body called Internal Shariah Supervisory Committee (ISSC) and their key responsibilities are:

• ISSC undertakes Shariah supervision of all business, activities, products, services, contracts, documents and code of conduct of the Bank.

• ISSC issues Shariah fatwas and resolution that are binding upon the Bank.

• ISSC monitors the Bank’s compliance with Shariah through the Internal Shariah Control Division and internal Shariah Audit.

To know more or read related topics, visit https://www.sc.com/ae/stories/basics-of-banking