The Islamic Finance and Banking System


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Sumaira Dada

Sumaira Dada is an independent education management professional.

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Image finance“O believers, fear Allah and give up what is due to you from the interest (usury), if you are true believers. If you do not do so, then take notice of war from Allah and His Messenger. But, if you repent, then you can have your principal. Neither should you commit injustice nor should you be subjected to it.” (Al-Baqarah 2:278-279)

Riba in the Bible

One would perhaps be a little surprised to learn that the commandment regarding the prohibition of usury (Riba) also occurs in the Bible.

“Thou shalt not lend upon usury to thy brother; usury of money, usury of victuals, usury of anything that is lent upon usury.” (Deuteronomy 23:19)

Key aspects of Islamic Finance

Islamic finance is popularly understood as that mode of banking, in which interest or Riba is forbidden. Although this aspect forms the crux of Islamic finance, there are also various other principles, according to the Shariah, that form the basis of an Islamic banking system which are:

Making money from money is not permissible: One of the assumptions on which all theories of interest are based is that money is a commodity. It is therefore argued that money can be bought and sold; bought in the form of deposits and sold in the form of loans. This is just as if a merchant can sell his commodity for a higher price than his cost, he can also sell his money for a higher price than its face value. Islamic principles, however, do not accept this assumption. Islamic financial institutions must trade in “real” assets or services. Money and commodity have different characteristics and therefore, they are treated differently.

Gharar (Uncertainty) is prohibited: Under this prohibition any transaction entered into should be free from uncertainty and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Thus, options, futures, and derivatives are considered un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.

Maisir (speculation or gambling) is not allowed: Transactions undertaken for purely speculative purposes are not allowed. Trading or investment transactions, which involve the risk of incurring losses as well as earning profits, do not fall under the definition of Maisir.

Investments should only support Halal activities: The Shariah does not permit Muslims to invest in any business or activity that involves the production of items or pursuit of activities that are considered to be Haram, or impermissible.

Role of a bank in the Islamic context

The functions of Islamic financial institutions can be divided into two parts: the safeguarding of deposits and the partnership of financial institutions with shareholders and depositors in profit-making ventures. Demand deposit facilities (called Amanah or Qard-Hasan deposits) are similar to safekeeping and transferable deposit functions performed in standard conventional banking. The Amanah or Qard-Hasan deposits pay no return and the financial institution is obligated to preserve the nominal value of the deposit.

The partnership activities of Islamic financial institutions have mixed features that include conventional bank intermediation, mutual funds or limited partnerships. To a large extent, Islamic financial institutions act as conventional intermediaries by issuing deposit-like instruments to the public in order to raise funds to finance commercial activities. The investments, many of which are negotiable and are known as “investment deposit certificates”, have properties similar to those of shares in a company or a mutual fund.

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