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Principles of Islamic Banking Research Team | Posted On Thursday, April 09,2009, 01:28 PM

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Principles of Islamic Banking



Principles of Islamic Banking

Islamic banking has the same intention as conventional banking apart from that it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat that is Islamic rules on transactions. The basic principle of Islamic banking is the distribution of profit and loss. Among the common Islamic concepts used in Islamic banking are profit sharing, safekeeping, joint venture, cost plus, and leasing.

In an Islamic mortgage contract, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. But, the fact that it is profit cannot be made explicit, so there are no additional penalties for late payment. In order to defend itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction, this is called as Murabaha. Another approach is EIjaras wa EIqtina, it is like real estate leasing. Islamic banks handle loans for vehicles in a similar way.
A new approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental, the bank and borrower forms a partnership body, which provides capital at permitted percentage to buy the property. The partnership unit then rent out the property to the borrower and charges rent. The bank and the borrower will then divide the proceed from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership body also buys the bank's share on the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. In case failure occurs, both the bank and the borrower receive the proceeds from an auction based on the current equity. This process allows for floating rates according to current market rate such as the BLR, especially in a dual-banking system like in Malaysia.
There are some other approaches used in business deals. Islamic banks provide their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. So the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal quantity of the loan is repaid, the profit-sharing arrangement is concluded, this practice is called Musharaka. Then, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements among capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.
Finally, Islamic banking is limited to islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the only suitable form of investment, and moral purchasing is encouraged. Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio. But, in practice, no examples of 100 per cent reserve banking are observed.
Islamic banks have developed recently in the Muslim world but are a very small share of the global banking system. Institutions founded by Muslims, especially Grameen Bank, use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. But, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, says that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury.

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