A Primer of Islamic Banking
Updated: Apr 27
By Mugdha Goel and Lavanya Joneja
Tools, principles and ethics
What is it?
Islamic Banking is premised on two things - profit and loss sharing, and no interest on loans. The instruments of profit and loss sharing were started in the 1970s, which laid ground for a postcolonial Islamic response to the introduction of banking in Muslim societies. The way it functions as well as the contracts it provides, are very different from a conventional commercial bank. When depositors put their money into Islamic banks, there aren’t any assured returns. The deposited money is used by the bank to purchase assets, which generate returns. When these returns are earned by the banks, part of the profit is given to the depositor and if losses are incurred, then even the depositors have to bear with it. The banks offer borrowers asset based loans, i.e. loans that need to be backed by assets as the collateral, therefore, if the borrowers default, the bank can take over their assets. Instead of earning profits by charging interest from borrowers, these banks earn profits by the use of equity participation systems through which the borrower pays back the loan along with a share in the profit instead of interest. Islamic baking has rapidly expanded in a number of countries all over the world, but the system is still finding it challenging to cope with the ever-changing global banking environment and making appropriate rules & regulations to cope with these changes, while still maintaining their conventional approach. Earlier, Islamic Banking was popular only in the Islamic countries, but now it’s being spread throughout the world. Saudi Arabia has the largest Islamic Banking market. The United Kingdom was the first non-Islamic country to start a sharia compliant financial institution- the ‘Islamic Bank of Britain’ as well as Islamic Bonds- ‘sukuk’. However, Islamic banks have not yet made their mark in India, even though there already exists an Islamic Bank in Kerala.
What are the tools?
There are two tools that emerge in Islamic Banking, namely “Musharakah” and “Mudarabah”, which are the driving force behind interest free banking, borrowed from Christian and Jewish traditions. In simple words, in a Musharakah setup, the bank and borrower enter into a kind of joint venture deal, wherein the capital is obtained not only from the banks, but from all the partners, and profits and losses are shared in the ratio of their respective investment. Since, Sharia Law does not allow the bank to profit from the interest by lending funds, Musharakah allows the financier to gain returns and share in the losses by being a partner in it in the predetermined ratio.
On the other hand, Mudarabah is a business contract wherein one partner invests the capital and the other brings in the personal skill required for the business. They share profits in the pre-determined ratio. With respect to losses, the silent partner loses the invested capital, and the other partner loses on the invested time and effort. Since, the partner who brings in the capital is the bank, it is the depositors who bear these losses because it was their money which was used to lend out the capital.
What are the principles?
Islamic Banking also promotes ethical financing. The Banks believe in not just giving funds as charity, but helping in social projects. The basic principle of Islamic banking is to not charge any interest or ‘riba’ while giving out loans. They do so because they believe that the investors start caring about the interest rates and their return on money when they invest their money in such banks, rather than the causes to which their money is being put to use, which eventually according to the Banks has a negative impact.
Islamic banking also operates on the general principles of inclusive growth, equitable risk sharing, social justice, and fair distribution of wealth. Since these banks only invest in profitable companies (as they do not charge any interest), this system of banking promotes distribution of wealth to those who really need it, rather than choosing borrowers based on social status or wealth, as is done in commercial banks. Therefore, unlike commercial banks who give out loans more easily to those who have a standing in the market as compared to those who really need it, Islamic Banks only give loans to those who they think have a profitable business plan.
Further, they also review the business to which their funds are being allocated. They review the businesses’ policies, services, products and, the impact of their products and services on the society and the environment. They scrutinize the activities of these companies to check if they comply with Sharia Law before investing their money.
However, the key question that arises is – “Does Islamic Banking really care about general ethical standards of the business they are investing in, or are they just concerned about equitable risk sharing . Other “ethical” banks, particularly cooperative banks in the UK for example, concern themselves with five broad aspects of ethics: human rights, armaments, trade and social involvement, environmental impact and animal welfare. Shariah-compliant Islamic banks have kept the definition of “ethical banking” very broad, and primarily focused on risk sharing. This makes us question the entire idea of ethics in Islamic Banking.