Islamic Banking

January 10, 2017

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There exist various religions that exhibit different values and beliefs. Muslim religion is one of them; its values and beliefs stand out from other religions, especially when it comes to banking. The rules pertaining to banking in the Islamic religion are guided by Sharia. Sharia is a system of law among the Muslims that guides their conducts and behaviors. It constitutes certain prohibitions, admonitions as well as commands that guide the behavior of human beings. The Sharia law also falls on those who are not Muslims and it makes life unfavorable for non-Muslims affected by these rules. The penalties granted under these rules are severe in case of violating them. This paper seeks to discuss the concept of Islamic banking under the Sharia law.


Islamic banking can be compared to any other type of banking; the only difference is that it is guided by the Sharia principle. Therefore, Islamic banking is a banking system guided by Sharia. Certain principles do exist that guide the ethical and moral values. The Islamic banks work under the rules of Sharia; it prohibits charging interest, riba, in the process of lending or payment of money. This prohibition was also in use in regard to other activities involving trade. The difference that exists between the conventional banking system and the Islamic banking system is that the Islamic banking is guided by its own unique law. Its applicability in Islamic development of economics also makes use of this law. The principles that guide the Islamic banking are generally widely accepted in the Muslim religion. Sharia bases its existence on Quran and the Hadith, the connotations by Prophet Mohammed (Iqbal & Mirakhor 3).

Islamic finance has been predominantly practiced in the world of Muslims with its tenets on business and trading activities. The Islamic banking was revived in 1976 when advent was celebrated world-wide.

Principles of Islamic Banking

Banking under the Islamic religion is guided by certain principles contained in Sharia. There exists a prohibition regarding pay, for example. Payment of charges on borrowed money or rent is prohibited under Sharia. Charging of interest rates is compared to usury and, thus, is totally prohibited in Islamic religion and, hence, referred to as Haram. Banks in the Islamic religion have been formed to comply with this principle (Institute of Islamic Banking & Insurance 1).

However, the issue of usury has been prohibited not only in the Islamic religion but also within Christianity. The Bible prohibits the practice of usury but does not prohibit profit gaining. Many writers, including Shakespeare, have negatively depicted the practice of usury in their works.

The Muslims consider money as a medium through which exchange occurs and, thus, it should not be used to generate more income. This is a tenet held by the Islamic religion; they believe that money is only employed to facilitate exchange and, thus, should not be used to generate additional value. They portend that money has only its default value and cannot generate extra value. There is no real lending under Sharia and lenders only get interests on ownership of the assets they take part in financing. Islamic bank will only earn income on the return from the non-monetary assets and not in charging of interest rates. Risk bearing according to the Islamic principle should always carry a reward. The applicability of this principle is seen in both capital and labor. Payment on labor cannot be rewarded without actual performance of the labor. In this sense, the reward for capital should only be allowed by exposing the same capital to business risks.

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Regulatory Agencies for Islamic Finance

The development in the regulatory measures has not grown handy with the growth in the sector itself. Efforts have been put in place with the objective of standardizing financial regulation on the Islamic banking practices. This aims the standards of accounting, management of risk, and capital requirements. There exist supervisory and regulatory guidelines set up with the sole purpose of regulating the financial activities within Islamic banking. Sharia Supervisory Board is given the mandate to advice and regulate the transactions within the banking system in the respective countries.

International bodies exist to support the financial industry within the international arena. The international bodies include the Islamic Financial Services Board (IFSB) among others. These bodies are mandated to provide guidance in regard to the financial activities by developing and guarding the standards in financial obligations. The banking sector, being a financial intermediary, is protected by the standards developed by these international bodies. The laws developed by these bodies have to be consistent with Sharia (Tiby 14).

Islamic Banking and Conventional Banking

Although Sharia rules constrain the banking system in the Islamic religion, the Islamic banks essentially perform the same functions as conventional banks. Both categories of banks are financial intermediaries as they are perceived to be economic administrators. Financial markets imperfections need to be addressed and, hence, the two banks serve this purpose. The market imperfections are caused by large demand for banking services that exceed supply. Banks enter into the market to fill this gap. Other examples of market imperfection include imperfect information, financial claims that are not perfectly divisible, and transaction costs among others. Both the conventional banking system and the Islamic banking system portray economies of scale with regard to the transaction costs. The financial intermediaries from the Islamic banking system turn their liabilities into various obligations according to the circumstances at hand.

However, there exist differences between the two banking systems. The Islamic banks highly condemn the charging of interest rates on money rent or on borrowed funds. The banks have to rely on sharing of profits. The securities offered are considered open-ended in terms of risk. On the other hand, conventional banking relies on interest rates as they majorly deal with carrying out transactions. The money borrowed from these institutions carries very high interest rates. The argument is that the interest rates charged serve as the major income of the banks and are used in funding the various transactions undertaken. While Muslims consider payment of interest rates as Haram, their conventional counterparts consider this a legal aspect not prohibited by any law. The financial securities attached to a loan are considered as ownership on the part of the bank. In case the borrower defaults in the payment of the money borrowed, the conventional bank can seize the property to recover the damage. The ethical values and principles among Muslims prohibit them from charging interest rates since they consider they compare the practice to usury. The non-Muslims do not consider this practice as usury. Although Christianity highly condemns the practice of usury, they make a clear distinction of interest rate and usury. They portend that the two practices are different concepts and are not comparable.

Risks in Islamic Banking

All banks, whether Islamic or conventional, are bound to incurring risks. These risks usually occur in the process of operations and are based on the rules and principles that guide the operations. Contractual designs of financial instruments, guided by Sharia, usually result to a mix of risks among the financial institutions in Islam. Institutions that offer Islamic financial and banking services have foundations that are different from their counterparts in the conventional banking. The Sharia rule among the Muslims is superior to any other rule and takes priority as compared to the profits. The risks that occur in general banking are also bound to occur in the Muslim banking. These include business, financial, operational, and the risk of an event.

Institutions on Islamic Financial Services (IIFS) have to perform under certain ideals. Exploitation between the financial service provider and the client is highly prohibited and institutions are supposed to promote the principle of fairness in all their transactions. The risks should be shared between principals in the financial transactions undertaken. This should also be applied when it comes to the reward awarded. The non-payment of interest and abiding to what is legally recommended under Haram is an issue that institutions of banking under the Islamic religion need to observe.

The nature of risk between the Islamic banking and the conventional banking differs to a large extent. The nature of assets is different between the two banks and, hence, there is a difference in the nature of risks.

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Advantages of Islamic Banking over Conventional Banking

Islamic banking may be considered more favorable than the conventional banking due to the advantages that it exhibits over the conventional banking. The Islamic banking serves to promote the principle of social welfare and justice as guided by Sharia while the conventional banking does not care about this principle. This reason makes the Islamic banking favorable among various clients since it is seen to promote non-discrimination measures.

In regard to the financial resources, the Islamic banking is seen to promote the welfare of the poor. The financial resources serve the disadvantaged and those beyond the poverty line within the society. This is due to the policy that it promotes regarding the non-payment of interest rates. Conventional banking does not have any concern regarding this group in the society. The investment plans implemented by the Islamic banking have a major objective of reducing inequality in terms of wealth and income by reducing the gap between the poor and the rich. Conventional banking, on the other hand, causes a huge difference among the various categories of income earners in the society. The arrangements conducted in Islamic banking regarding the investment funds are focused on the poor and those without assets, even if they are physically fit, while their counterparts develop plans targeting the rich in the society. This is because their main objective is to earn an income that is mostly based on the interest rate.

In regard to the risk, Islamic banking becomes partner to the client in the business as it assists in bearing of losses. The relationship created by this bank is a friendly one and does not serve the principle of discrimination or exploitation in any undertakings. Conventional banking, on the other hand, does not incur any losses; they are rather incurred by the clients. The relationship that exists is that of creditor-debtor. Projects funded under conventional banking have to meet the minimum level of interest rates. Islamic banking considers investment projects that are socially needed regardless of any stipulation in regard to the interest rates (Hassan & Lewis 98).

Islamic banking practices are guided by and operate under the principles of the Sharia law. The banking practices highly disregard the payment of interest rates. This factor distinguishes this type of banking from the conventional banking. The concept of Islamic banking is held with high regard amongst the Islamic faithful.