The Islamic Banking: Principles of Practice – Free Essay Examples

The Islamic Banking: Principles of Practice

Introduction

Islam is the second-largest religion after Christianity. It is also the fastest growing with members joining it every day. Being a Muslim means abiding by the set rules as governed by the holy teachings. One of the components of religion is the belief in Sharia laws, which are the Islamic rules and jurisprudence (Hassan & Lewis, 2007, p. 1). Sharia laws constitute a set of ethical teachings and conduct practices as derived from the Islamic holy book of the Quran and the teachings of Prophet Mohammed (Hassan & Lewis, 2007, p. 1). According to the Sharia laws, there are components in the conventional banking system to which a Muslim is not supposed to be a party. This notion has led to the development of an alternate financial banking system otherwise referred to as Islamic finance or banking following the Islamic guidelines.

Islamic banking has grown in significance over the past century. It is now practiced in many Islamic countries besides being offered by institutions in countries with Muslims in their populations. Some of the countries with these banks include Iran, Malaysia, Singapore, Pakistan, Sudan, Bahrain, Jordan, and the UK. It has grown from small institutions meant to follow Islamic law to a multi-billion dollar industry that upholds Islamic law (Iqbal & Molynex, 2005, p.2). In the Sharia context, there are components of conventional banking that are not permissible. According to the holy writings, these are the Maisir, Riba, and Gharar. Riba is the Islamic term for the interest that conventional banks use in their transactions otherwise known as usury. The Sharia law forbids its adherents from making a profit from money without having taken part in things such as risk-taking, trade, or any money earned without putting any effort. However, the profit gained after carrying out trade is acceptable.

Gharar is a characteristic of conventional baking is uncertainty denoting the selling of items with ill-defined and uncertain characteristics. This evil has been closely linked to gambling due to its vague and precarious nature (Hassan & Lewis, 2007, p. 1). The conventional financial systems utilize these characteristics in activities such as insurance and some derivative contract (Hassan & Lewis, 2007, p. 1). An alternative to this practice is the practice of Takaful, which is a form of insurance that is Sharia-compliant. Takaful does not incorporate practices and qualities such as gharar or Riba. Therefore, it is safe for Muslims who treat it as one of the concepts practiced in the Islamic banking systems that are gaining acceptance around the world.

Maisir is the Islamic term for gambling, which is also forbidden in Sharia law. The reason behind the maisir being forbidden is thought to be a protection strategy from the participants in finance from the perceived harm it may bring to them. People should avoid games where they are likely to win big prizes because their luck may be against them someday thus ending up losing large sums of money instead. Islamic banking should therefore take into consideration these qualities to provide services devoid of maisir, riba, or gharar. The conventional banking system is thought to consist of forbidden qualities. All Muslims should therefore avoid it to ensure respect to their creator to avoid the problems associated with this banking system. Therefore, the essay focuses on the principles and practices of Islamic banking, the services it provides, and the differences with the conventional banking system.

Islamic Banking Principles and Practices

According to Hasan, “The General Secretariat of the Organization of the Islamic Conference (OIC) defines an Islamic bank as a financial institution whose statutes, rules, and procedures expressly state its commitment to the principle of sharia and the banning of the receipt and payment of interest on any of its operations” (1999, p. 23). Islamic banking incorporates a variety of concepts and principles, which differentiate it from conventional banking to ensure its adherence to the Sharia laws. Murabahah, Bai’ ai-inah, Mudharabah, Wadiah, sukuk, Ijarah, and Wakalah comprise the principles to be discussed in detail with an explanation of how they make Islamic banking unique. These are the basic principles and concepts of Islamic banking, which represent the main differences between the conventional banking system and the Islamic form of banking. As demonstrated later, they are based on the avoidance of interest and charges levied on loans and other parts of transactions. These were originally spelled out in the Quran to protect the Muslim faithful from losses in business.

Murabahah

Murabahah is an Islamic banking principle that is meant to overcome the Sharia hurdle of interest. This concept refers to the “sale of goods at a price, which includes the profit margin as agreed by both parties” (Hassan & Lewis, 2007, p. 8). The concept holds on the condition that the seller states the pricing, other costs, and his or her profit margin when making the agreement. Murabahah dealing therefore necessitates the sale of commodities at a cost, which involves the profit margin harmonized by both people. According to Hassan and Lewis (2007, p. 11), “The seller must let the buyer know the actual cost of the asset and the profit margin at the time of the sale agreement”. An example of Murabahah is a transaction between a businessperson and a bank. The bank states the pricing of the products it is offering to the businessperson or investor and then proceeds to tell him or her the price at which it is going to provide. After a period of bargaining, both parties agree to the price. They are both aware of the profit margins that the bank is going to make. The Murabahah concept enables transactions, which would mainly involve the charging of interest in conventional banks to be carried out with respect to the Sharia laws. It also offers security to the Islamic community by ensuring that the prices of services are regulated and or are not overcharged. Maisir and Riba are therefore avoided since both parties are aware of the profit margins thus not qualifying as interest as would apply in the conventional banking system.

Wadiah

Wadiah is an Islamic banking concept, which is commonly interpreted as safekeeping or custody. In a wadiah agreement, a person deposits assets or cash in a financial institution that guarantees its safety (Hassan & Lewis, 2007, p. 12). The intention of the person depositing the property or money is to have it in a secure place not to earn interest, which is also the intention of the financial institution or bank. In the conventional banking system, both parties in this kind of transaction are interested in earning interest from the assets. The wadiah, therefore, guarantees that people respect and adhere to the Islamic principles stated in the Sharia laws. How does the concept work? One deposits his or her money or assets in a bank, which guarantees returns in the same amount and shape as deposited. The bank allows the client to withdraw the money or part of it at any time during the transaction period. The bank may however charge a certain amount to the client for the safety of money or asset deposited with it and may also give the client a gift in some instances (otherwise known as hibah) if it deems it necessary. The wadiah “…concept is normally used in deposit-taking activities, custodial services, and safe deposit boxes” (Hassan & Lewis, 2007, p. 13). In this concept, there are options for the level of protection accorded to the asset or money deposited for safekeeping. Wadiah Yad Amanah principle refers to a kind of wadiah where the party or bank entrusted with the security of the asset does not bear responsibility for any damages or losses of the funds or goods entrusted to it unless as the consequence of his or her negligence (Hassan & Lewis, 2007, p. 14). The bank is however not allowed to use the funds or assets for investment purposes. Nevertheless, this type of transaction is a more possible application of this principle in safe deposit boxes. In this principle, person Y entrusts his or her property for safekeeping to person X with Wadiah referring to the property.

The second principle in Wadiah is Wadiah Yad Dhamanh, which is protected safekeeping as applied mostly to transactions involving funds. In this principle, a person deposits his or her property or funds with a bank for safekeeping. Wadiah here becomes the trust. The “depository becomes the guarantor who therefore guarantees repayment of the total amount of the funds or property deposited, or any part thereof outstanding in the accounts of the depositors when demanded” (Hassan & Lewis, 2007, p. 14). The bank in this transaction is allowed to invest with the property entrusted to it. The owner may be compensated fully in the case of loss or damage of the property under the guarantor’s hands. In the case of the success of the guarantor in the investments made using the property, the depositor is not legally entitled to the profits. However, the depository may opt to provide a gift or Hibah to the depositor as a means of appreciation (Hassan & Lewis, 2007, p. 13). According to the Sharia-adherent transactions, the Hibah or gift is “an act of transferring of ownership of an asset or usufruct without an exchange of the counter value during the lifetime of the transferor” (Hassan & Lewis, 2007, p. 15). There is no agreement in the transactions that guarantees the giving of this gift. A person who had borrowed a loan with success can also make it. The price charged for the safety of the assets deposited with the bank is not equivalent to interest according to the concept. In most instances, it is fixed for a certain amount of money or property. It does not increase with the duration of the storage unless specified in the contract. The Wadiah concept is also a way of ensuring respect to the Sharia law since it avoids riba and any interest-related transaction.

Mudharabah

Mudharabah is a concept that allows two parties in a financial transaction to benefit mutually from it. It has been described as a “profit-sharing arrangement between two parties, that is, an investor and the entrepreneur” (Hassan & Lewis, 2007, p. 17). In this transaction, the bank provides capital through a loan to an entrepreneur. The money will be returned in full to the investor (bank) including a certain proportion of the profits that the entrepreneur gets from his or her investment as agreed before the release of the funds. The application of this principle can be made in two ways in Islamic banking operations. In the first instance, the agreement is made with the bank acting as the entrepreneur and another institution acting as the provider of capital. The bank invests the money and gets to share the profits in a prefixed ratio with the capital provider. In the second instance, the bank is the source of capital while another party that receives it is the entrepreneur. The entrepreneur invests the money and returns it in full to the bank with the agreed portion of the profits. In both instances, the providers of capital are the ones to bear the losses made. Therefore, they have to ensure that the projects being partaken are profitable through scrutiny. In an example of this principle, “…person X supplies funds or assets to a certain bank Y after both parties agree on the Mudharabah arrangement terms” (Hassan & Lewis, 2007, p. 17). The bank proceeds to invest the money in projects deemed profitable to it. This may be real estate, companies, or even manufacturing industries. This investment may result to profit or loss-making depending on the prevailing financial situations of the projects invested. After the period of investment is complete, the profits made by the bank are shared with the investor in the agreed-upon ratio. In the case of losses, the value of the funds that person X paid the bank will reduce. This means he or she bears the greatest responsibility in the case of losses. However, there are limits to the amount of loss that can be transferred to him or her since it cannot exceed the amount of money he or she deposited with the bank for the transaction.

Bai’ Bithaman Ajil

Bai’ Bithaman Ajil refers to “the sale of goods where the buyer pays the seller after the sale together with an agreed profit margin either in one lump sum or by installment” (Hassan & Lewis, 2007, p. 19). This principle applies where a person would like to buy an asset while unable to raise funds for a single transaction. He or she, therefore, approaches the local Islamic bank to facilitate the purchase. The bank considers this agreement. After agreeing to it, the two parties set up terms by which the person will pay the bank. As an example, a person picks an asset that he would like to purchase from the institution or company of his or her choice. This may be a building business venture or any asset that he or she cannot raise money to acquire. Therefore, under the Bai’ Bithaman Ajil agreement otherwise known as the deferred payment sale, such a person can approach the local bank to request it to buy the asset (Hassan & Lewis, 2007, p. 1). The bank agrees to this and sets up terms for the acquisition. The main one is that the people for whom it buys the asset will buy it from them in a resale at a mark-up price (Hassan & Lewis, 2007, p. 1). The bank then proceeds to buy the property from the agreed outlet or source and becomes the new owner. Under the Bai’ Bithaman Ajil agreement, it then transfers the ownership of the asset to the individual or group, which then pays the amount to the bank in installments with the period of payment being set by both parties. This agreement is also formulated to bypass the Sharia law, which does not allow interest to be charged in the transaction. Both parties end up benefiting from the transaction. In a conventional banking system, the asset would belong to the bank until the total amount is transferred to the bank.

Masyarakat

In the banking industry, Musyarakah is the term used to define a joint business venture. In this venture, two people or institutions enter into a business partnership with the aim of making profits. The partnership may be between a bank and an individual or a group of individuals. The profits gained “are shared basing on an agreed ratio or in the same proportion as the amount of investment made by the partners” (Hassan & Lewis, 2007, p. 19). However, in the case of losses, they will be shared “based on the ratio of funds invested by each partner in the partnership” (Hassan & Lewis, 2007, p. 23). This agreement is not new in the conventional banking system. It is just similar here. The liability falls to both partners in the proportion of their contributions. This, therefore, means that the Sharia law does not impede partnership businesses in the transactions.

Ijarah Thumma Bai’

This concept is normally referred to as hire purchase in the conventional banking system. It is more commonly used to finance consumer goods, especially motor vehicle purchases (Hassan & Lewis, 2007, p. 1). Ijarah Thumma Bai’has two types of contracts from which individuals may choose based on the desired mode of financing. The first contract that is referred to as the Ijarah contract involves leasing or renting while the second one, the bai’ contract, involves purchasing the item in hire purchase (Hassan & Lewis, 2007, p. 1). As an example of this agreement, person X would like to have a certain kind of car that interests him or her but cannot raise the required amount. He approaches a local bank Y, “asks for Ijarah of the car, pays the deposit for the car and promises to lease the car from the bank after it buys it” (Hassan & Lewis, 2007, p. 1). The bank will then proceed to buy the car from the outlet of choice. Ownership now shifts to it. The car is then delivered to person X who has to pay the lease for a given period to the bank for the use of the car. The lease or Ijarah is paid over a given period by person X to bank Y. At the end of this predetermined period, the bank transfers ownership to person X who then pays the bank the agreed amount of ownership.

Wakalah

In the conventional banking system, an agency is a party in an agreement, which acts on behalf of another party in business transactions. In the Islamic banking system, Wakalah refers to this agency acting on behalf of a person (otherwise known as the principal). The agent receives payment for the services he or she provides to the principal, which can be in terms of interest for the amount transacted. As an example, a person may be involved in a transaction with a given company or service provider. The person then proceeds and asks his or her bank to pay the company or the other party with terms on which they agree. The bank “…is, therefore, the person’s agent for carrying out the financial transaction” (Hassan & Lewis, 2007, p. 27). It will receive a set amount of money as a fee for its services.

Qard

One of the most significant transactions that earn conventional banks their wealth and assets is the money earned from interest charged on the loans they offer. With Islamic banking, interest should not be charged on loans as the Quran prohibits it referring to it as riba. The Islamic banking system, therefore, offers Interest-free loans to ensure their clients enjoy the same services as other religions. In the qard arrangement, the bank offers a certain amount of money to an individual as a loan over a specified amount of time. This offer is made on a goodwill basis with the borrower being only required to pay the amount that he or she borrowed (Thomas, 2006, p. 12). The borrower may however pay the amount with a benefit as a gift to the financing institution in gratitude. This benefit is not specified or made mandatory when the client is receiving the loan. The amount of the gift (hibah) depends on his or her success in its use. An example of this concept is where a person approaches a bank for money to buy a property. The bank sets the duration of payment as five years. At the end of this period, the bank expects the sum of money it provided to the individual to be paid in full. However, the individual makes payment to the bank in excess of some money and considers this the gift. This is an example of an interest-free loan, which does not contravene Sharia law. The gift in this case is not considered as interest since it is not predetermined or fixed.

Sukuk

Sukuk is the Arabic term for Islamic securities (Thomas, 2006, p. 12). It means certificates. In the conventional banking system, securities are sometimes associated with liquidity. They are then referred to as bonds. There however exist differences between bonds and Sukuk as applied in Islamic banking. Various definitions of Sukuk exist with some schools of thought defining it as “a document or certificate representing the value of an asset with an asset meant to include financial asset such as receivables and debts, as well as non-financial assets like tangible assets, usufructs, and services” (Thomas, 2006, p. 12). The amount of money that is returned to the investor in the conventional banking system is inclusive of the interest earned. In the Sukuk, the amount is the same as provided. Any extra amount is just the profit, which was set prior to the agreement or the gift. In the conventional banking system, the holder of conventional bonds owns the cash flow only while he owns the assets as well as the right on the cash flow in the Sukuk. In conventional bonds, the contract creates a loan situation between an individual and a financial institution with one party being indebted to the other. This case is replaced by different contracts in the Sukuk. Instead of creating debt, it ensures obligation between the parties involved including partnerships, joint ventures equity, lease, and sales (Thomas, 2006, p. 12).

Islamic Banking Development

The concept of Islamic banking is barely half a century old. Before the dawn 1970s, “Islamic banking was considered “wishful thinking” that was only considered possible after the launch of the First International Conference on Islamic Economics organized by King Abdul Aziz University in Makkah, Saudi Arabia” (Iqbal & Molyneux, 2005, p. 12). The prospects of Islamic banking were later approved after the first commercial Islamic bank in Dubai, which started as the Dubai Islamic Bank (DIB) in the UAE (Iqbal & Molyneux, 2005, p. 12). This bank was later followed by an internationally acclaimed bank namely the International Islamic Development Bank (IDB) in Saudi Arabia followed by many private banks in the Islamic states of Sudan, Egypt, Kuwait, and Bahrain (Iqbal, & Molyneux, 2005, p. 12).

Again, this effort was in respect to the need for an alternate financing system for the conservative Islamic communities and especially those that were strict followers of the Sharia law. It was also thought to be an alternative of “financial intermediation and an efficient and productive way of undertaking financial intermediation between surplus and deficit economic units” (Iqbal & Molyneux, 2005, p. 12). Since this period, Islamic banking has considerably grown to include many financial services in different parts of the world. The rate of growth has even hit the double-digit mark on several occasions. This achievement has contributed towards making this venture a multi-billion dollar industry. Some authors have continually called this industry a boom stating that the concept will persist for long.

In the year 1975, the industry was only worth a few hundred thousand dollars. However, this value has increased over the past quarter-century with an estimated hundreds of billions of dollars changing hands in the industry in the year 2005 (Iqbal & Molyneux, 2005, p. 12). This realization has led the industry to be considered among the fastest growing in the world. The concept of Islamic banking is now international. It “is now not limited to only Arab and Muslim countries though it has spread from East to West all the way from Indonesia and Malaysia towards Europe and America” (Iqbal & Molyneux, 2005, p. 1).

The concept has enabled thousands of people to benefit from a banking system that they can establish since it also offers an alternative to the conventional banking system as demonstrated in many countries around the world. The trend has gained popularity over the years. As Iqbal and Molyneux state, “many conventional banks including some major multinational western banks have also started using Islamic banking techniques” (2005, p.1). It is also reported that the world is yet to establish the total spread of these banks and that there is evidence that it is spreading throughout the five continents (Al-Iqtisadiyah, 2005, p. 56). In the year 2005, the Islamic banks in the world numbered 280 in 48 countries, with a deposit of around 400 billion US dollars with over 300 conventional banks opening branches that provided Islamic financial products (Iqbal & Molyneux, 2005, p. 11). Currently, the number has grown with over 400 conventional banks offering these services. The number of Islamic banks has increased to over 300 in the Islamic nations.

This progress is remarkable since the banks are now providing these services at appropriate standards. The Islamic banking system however is insignificant in size compared to the conventional banking system. Iqbal and Molyneux state, “if the assets of all Islamic banks were pooled, they would still be less than those of any single bank in the top 50 banks in the world…the assets of the largest Islamic banks are equal to only 1 percent of the assets of the largest bank in the world” (2005, p.132). This however does not mean that the progress made is of no use. It only means that there is still more to be done in this financial system.

The origin of the Islamic financial system dates back to long times in history when the Muslim world was in the dark ages. In the middle of the nineteenth century, almost all the Muslim countries had adopted laws and legal systems with the western systems as an influence based on the witnessed direct or indirect pressure (Chachi, 2005, p.13). This was not only apparent in the legal system but also in the banking industry where Islamic commercial models were abandoned for the western form of banking and business models (Chachi, 2005, p.13). When these nations gained independence, foreign banks were nationalized. As such, the concept of national banks was later established. The influence of overseas banks was reduced though it was however replaced by a banking system that was largely considered as ‘neo-colonial’ (Chachi, 2005, p.15). With the establishment of these banks, the interests of the common Muslim society in these countries were not considered as the religion, which plays an important part in their life, was not adhered to. Sharia law was not respected in this system. Consequently, the society was therefore being subjected to alien practices. With this consideration, “the idea of establishing ‘Islamic banks’, which would not only offer all banking services but also which would not break or violate the religious beliefs of the people arose” (Chachi, 2005, p.13).

The idea, therefore, developed after the Islamic states gained independence from their colonial masters with this happening between the 1930s and 1950s. The first recorded attempt to create an Islamic bank according to Chachi is said to be in the late 1950s in a rural area of Pakistan though the effort had no lasting impact (2005, p.15). The bank had been established to deal with the deposition of funds by landowners in the area without an interest being charged. The money would then be loaned to poorer landowners who would use it to improve their agricultural output. There was no interest in the transactions. Rather, only a meager service fee was meant to facilitate the banks’ operations. With time, however, the bank ran out of cash to proceed with its operations since the number of those depositing the money reduced. Those who still deposited with it also developed an interest in how their money should be spent. This effort reduced the autonomy that the bank’s officials enjoyed (Chachi, 2005, p.16). With the end of this experiment, a new one started in Egypt in 1963. According to Chachi, “the Mit-Ghamr Islamic Savings Bank (MGISB) started in the county of Mit-Ghamr in Egypt by El-Naggar who later became the Secretary-General of the International Association of Islamic Banks” (Chachi, 2005, p.16). The idea was to use the funds in the population that was not in any use and use them to provide returns to the population on its savings without contravening the Sharia law.

To win the hearts of the locals, the bank employed Muslim bankers from around other financial institutions. This strategy was considered an easy way of gaining the trust of the locals, especially the peasant farmers who had always been suspicious of the other financial institutions. According to Chachi, the founder of the bank el-Nagger stated the concept of the bank is constituting of three roles. These were, “first, to act as an efficient intermediary between the supply and demand of capital, second, to act as an educational center for economic efficiency, saving education and banking habit, and third, to set a dynamic factor in mobilizing the idle capital for investment thus reducing hoarding and the problems of capital formation” (2005, p.13).

The bank provided loans to the Muslim society in the town and rural areas around. The loans had various uses with the main ones being related to agriculture. In the next period of years, the bank grew in membership enlisting more than 200,000 new members in a period of three years. The bank however ended after a period of three and a half years of service to the local population. Its termination was due to political reasons beyond its control (Chachi, 2005, p.17). The changes brought about by it were however evident in the society in which it had operated, as the social standards of the people had improved. The agricultural production had also been improved through the loans it provided.

With the exit of the bank, the prospect of an Islamic banking system did not stop there. Many other banks elsewhere applied the same principle applied here and used it to provide financial solutions respecting the Sharia law. The bank was followed by another one in the same country referred to as Nasser Social Bank, which was established in the year 1971 as a bank to serve the needs of the population in the low social class (Chachi, 2005, p.17). It was not to make any profit. It would facilitate the financial solution of those people previously considered ‘unbankable’ (Chachi, 2005, p.17). It is with this idea of a bank following the Islamic Sharia law that the governments of the Middle East nations, which are mainly Islamic, developed the intergovernmental banking institution in 1975: the so-called Islamic Development Bank (IDB) (Chachi, 2005, p.17).

This bank was supposed to accelerate the economic development of her member countries while allowing them to act within the narrow confines of Sharia law. The same year saw the development of another Islamic banking institution in Dubai in the United Arab Emirates, which came to be known as the Dubai Islamic Bank (DIB) which is located in the commercial capital of the confederation, Dubai (Chachi, 2005, p.17). This particular institution was marked by major success. It inspired the development of a number of Islamic banks elsewhere.

In the same period that the Mit-Ghamr savings bank was operating in Egypt, another institution of its kind was also functional in Malaysia. This is the Pilgrims Fund Corporation or Tabung Haji, which started its operations in the year 1963 (Chachi, 2005, p.17). The institution however was not an actual bank. It had a variety of objectives for the Muslims in this country. Its objectives were to facilitate the pilgrimage of the Muslims to the Hajj by allowing them to save for this particular cause. It also targeted the provision of financial security for these Muslims in the Hajj besides enabling them to save for other things within the Sharia law. At its start, the organization had few members. As Chachi states, it had only, “1281 members and total deposits of MR46,600…the quasi-government body now has a membership (account holders) of around 4 million and deposits of more than US$2 billion” (2005, p.17). The institution currently has a large number of outlets in the country. It has large numbers of members allowing it to compete with the conventional banks in the country.

The money that the members save is subjected to Sharia law. The investments are therefore in a number of specified projects across the country. Currently, the Islamic banking principle is applied in many countries with the main application being in the Islamic republics. The practice is however catching up in many of the westernized conventional banks, which are now offering the services available in an Islamic bank to their Muslim clients. The banking system has been Islamized in a number of countries such as Pakistan, Iran, and Sudan. There are also several Islamic banks in the countries of Egypt Jordan, Qatar, Turkey Algeria, Senegal, Tunisia, Bahrain, Kuwait, and Malaysia with others being established elsewhere in the Islamic and non-Islamic countries.

There are also Islamic banks in the west now with the Islamic services being rolled out in the major banks. Western countries with banks providing these services include England, Switzerland, Luxembourg, and Denmark (Chachi, 2005, p.17). The sector has been credited as one of the fastest-growing gone in finance. Most of the major banks in the world have opened their windows to this opportunity. Not only is the Islamic banking system being embraced in the world but also other components of the Islamic financial system are also catching up. There are insurance companies, which are referred to as Takaful besides other investment companies (Chachi, 2005, p.17). These companies have provided an alternative financial solution to Muslims in the capitalistic world.

The concept of Islamic banking has ensured that the Muslim society is able to bank and transact within the Sharia law, which was considered one of the factors causing their reluctance to invest in the conventional banking system. This case was highlighted in one of the instances where it is claimed, “on its first day of opening to the public the Kuwait Finance House, the Islamic Kuwaiti bank received KD50m (US$140m) transferred from deposits of the commercial banks” (Chachi, 2005, p.17). Data on the Islamic banking system shows that they are among the leading banks in the Islamic world, with assets putting them among the top 100 Arab banks. Currently, the Islamic banking system is well-positioned to compete with the conventional banking system. The Muslim population is increasing in number. Conversions are made every day hence comprising one among the factors that will ensure the concept is propagated through generations.

The growth of Islamic banks is clearly shown by the use of graphical representation. One common characteristic is the steady growth that the industry has experienced with the global financial crisis posing a little-observed threat compared to the conventional banks. As of the year 2009, Islamic banks were located in over 50 countries in the world with the main locations being the Middle East and North Africa (MENA) region. Islamic banking has gained momentum. Its market share in many economies is increasing as evidenced by the graph below

Market share of Islamic Banking

In the wake of the global financial crisis, Islamic banks were able to achieve growth in the same period. Thew growth was established both in the assets and funds available to the banks with a number of Islamic Banks and branches being opened. The industry has elicited competition with some people suggesting that it is just a scheme to get the Muslim community to invest in them. The growth in the time of the global financial crisis is depicted in the graph below.

The growth in the time of the global financial crisis

Asset growth for Islamic banks marked the largest growth achieved in the industry. This was in the form of investment in real estate and other development projects in the countries in which the banks were located. A good number of Islamic banks experienced growth in assets in the year 2010 with Iran having the largest asset base for the banks. This was followed by Saudi Arabia with the two nations having Islamic Banking systems in their national policies. Malaysia and the United Arab Emirates closely followed Saudi Arabia. The assets here were in the range of 35 billion dollars. Quwait, Bahrain, Qatar, Turkey, and Sudan closely followed the other countries with the remainder of the asset growth being distributed among other countries with Islamic banks. The growth in assets in the countries where Islamic banks are dominant marked the largest growth of these institutions. This case is highlighted in the graphs below.

Breakdown of the world's 100 islamic banks

Compared to the conventional banking system, Islamic banks have a larger market share in the MENA region. The existing population whose main belief is Islam may explain this claim. The target population is therefore located in the region. The pioneers of this system of banking were also from the region. In other areas, however, conventional banking is strongly entrenched with only a small portion of the market being available for Pure Islamic Banks. The graph below shows this distribution in market share for the various countries in which Islamic banking is operational.

Distribution in market share for the various countries in which Islamic banking is operational.

The oil market has continually supported the growth of Islamic banks. They enjoy their growth with the growth of the Oil industry. The Islamic securities offered by Islamic banks have grown over the years with conventional banks and individuals investing in the same. The Sukuk securities have therefore quadrupled in the past number of years with the most significant recorded change being between the years 2004 and 2006. The graph below illustrates the growth in Sukuk between the years 2004 and 2007.

The growth in Sukuk between the years 2004 and 2007

The concept of Islamic banking may be relatively new to the banking Industry. However, it has comfortably taken the market by storm. As indicated above, it is one of the fastest-growing industries with billions of dollars worth of trade being transacted. This industry has survived the global financial crisis. It is proving to be a strong force in the market.

Differences between Islamic banking and the traditional banking system

As discussed in the principles and functions of Islamic banks, many differences emerge between them and the traditional conventional banking system. The main difference between these two modes of banking is the fundamental foundation of the Islamic Bank on the principles of Sharia law. All transactions in the Islamic banking system, therefore, are geared towards respecting this religious quality of the Muslim society. An Islamic bank consists of all the activities of the conventional banking system with the main exclusion being the interest that is charged to money that is lent or borrowed because there should be no interest or riba as it is known, charged on any transactions in the Islamic business dealings according to the sharia law. This form of banking is therefore more of a lifestyle to the Muslim society and not a financial option as it is in the traditional conventional banking system.

To understand the differences between the conventional/traditional banking system and the Islamic Banking system, it is important to understand the principles behind the Islamic bank. These as highlighted above include the absence of interest (riba) in the financial transactions, the prohibition of engagement in oppressive economic activities (Zulm), and prohibition by the Sharia law in engagements and financial activities that involve speculation (gharar) (Hj Abd Rahman, 2007, p.1). Other principles include the mandatory Islamic tax called zakat and the discouragement of production of goods and services, which would go against Islamic values or haram (Hj Abd Rahman, 2007, p.1)

On the part of the conventional banking system, the relationship that exists between the bank and clients is that of a creditor and a debtor. Interest is the main money that is charged by conventional banking institutions. It is considered the price of credit reflecting the opportunity cost of the money (Hj Abd Rahman, 2007, p.1). In Islamic banking, the bank should lend its money without an interest being charged to it. This creates a situation where the bank has few opportunities to make money out of the transaction. The Islamic bank is therefore not based on the creditor-debtor relationship that exists in the traditional banking framework (Hj Abd Rahman, 2007, p.1). The other principle guiding the financial transactions in the Islamic banking system is that there should be no reward without taking any risk. This means that the bank would earn the interest without having to work for it by charging interest on money that is deposited with a bank since the Sharia law prohibits this attempt (Hj Abd Rahman, 2007, p.1). The above differences between the principles of the Islamic and the traditional banking systems are the defining ones. However, other unique features of the two systems make them different as discussed briefly below.

The first difference between them is the modes of operation. In the Islamic banking system, the principles of Sharia law are the template on which the functions and operations of the bank are based (Hj Abd Rahman, 2007, p.1). This means that there is interference from the lifestyle of the community involved in the system. The principles, as understood, are therefore divine. They have to be followed to ensure one is accepted in society. The conventional banking system however operates on principles that are manmade and not based on any interference from the spiritual life of its members. The original idea of the conventional banking system was also to serve all the populations irrespective of their faith while that of Islamic banks was to fulfill the financial needs of the Islamic religion.

The other difference between the traditional banking system and the Islamic system is the charging of interest. In the traditional/conventional banking system, the investor is assured of a predetermined interest rate (Hj Abd Rahman, 2007, p.1). This is set on a particular point that serves as the profit that the bank makes on the transaction. On the other hand, Islamic banking promotes risk-sharing between the capital provider and entrepreneur who use the funds (Hj Abd Rahman, 2007, p.1). The method of sharing these risks is set by the various transactions described above though this is not considered as interest. The investor however may receive a gift from the entrepreneur as an appreciation for the services provided. This is not mentioned in the contract: it is optional. This too is because of the Sharia law prohibition of Riba.

The third difference between the Islamic banking system and the traditional banking system is profit. For the traditional/conventional banking system, the investors maximize the profit margins in any transaction in which they engage without consideration of the background or the social status of the person seeking the services. Profit is therefore the main reason for the existence of the conventional banking system. This reason is not subject to any restrictions. The Islamic banking systems also “…aim at maximizing their profit, but this is subject to the Sharia restrictions” (Hj Abd Rahman, 2007, p.1). For a bank that hopes to be profitable in the Islamic banking field, the restrictions of Sharia law regulate this for the benefit of the Muslim people who are its main clients. This however is not a barrier since there are other services involved.

The Islamic banking system has had significant changes over the decades since its inception. One of these is the inclusion of the zakat, which is the Islamic tax that is levied on institutions to fund the operations of the social services. In Islamic banking, the Zakat is charged to the clients of the bank. The bank also pays this tax thus ending up transferring it to clients in transactions that they carry out. According to Hj Abd Rahman, “in the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre for them to pay their Zakat” (2007, p.1). For the conventional banking system, the zakat is non-existent. The only tax paid is levied on it by the government.

In the conventional banking systems, compounded interest is the mainstay of their operations in the financial world. In this operation, the amount of money that interest is charged includes the interest that the original amount had earned. Money lent is therefore paid back with the inclusion of the compound interest that it earned within the time of the transaction. For the Islamic banks, however, the business is in partnership with its clients. This means that they have to understand the needs of their market. As Hj Abd Rahman (2007, p.1) states, “Participation in partnership business is the fundamental function of the Islamic banks…people have to understand their customer’s business very well”. This means that there is no room for compound interest in the services that the institutions charge.

Since the conventional banking system has no limitations as it applies to the Islamic banking system, it can afford to include and charge additional funds in its transactions. This applies mostly to people who default on the payment of funds allocated to them by the banks. Those who take longer periods to pay are charged a large amount of money as compound interest. The bank also has powers to forcibly reprocess the money by obtaining the collateral of the client or other assets for use to recover its money. For the Islamic banks, however, there are no extra charges for their services. Defaulters are charged the same amount that they took from the bank. The bank however may receive compensation from the defaulter. In most instances, compensations are given to charity organizations. According to Hj Abd Rahman, “Rebates are given for early settlement at the Bank’s discretion” (2007, p.1).

As a common principle in the starting of any bank, the aims are to serve the interest of the community or country in which it is established. This is the main function of the traditional banking system and the Islamic system. A difference however occurs in the course of their development as they increase in subscriber base and wealth. For the traditional banking system, the bank more often than not abandons its interest to serve the society thus ending up perusing its interest. According to Hj Abd Rahman, these banks make no effort to ensure equitable growth (2007, p.1). For the Islamic banks, the public interest is one of the qualities that it gives importance. It, therefore, ensures growth with equity (Hj Abd Rahman, 2007, p.1). It, therefore, lives to perform its original intentions on the establishment.

In the traditional banking system, the bank is allowed to borrow from the money market. This case is possible for both systems of banking, but there exist differences in the ease of doing this for them. Since the traditional banking systems are mainly interest-based, they have easier tasks of borrowing from the money market (Hj Abd Rahman, 2007, p.1). This appears to be harder for the Islamic banks, which are not based on compound interest. Any transaction with another institution requires that the Sharia law be followed. In his article, Hj Abd Rahman states that any underlying transaction made by the Islamic banks should have approval by Sharia law (2007, p.1).

The traditional banking systems also differ from the Islamic banking systems by the projects that they carry out to earn profit. For conventional banks, the income they get is fixed. Therefore, the client will have to eventually pay a fixed amount as stipulated in the interest rate. The banks, therefore, have a little interest in projects that the client is carrying out with their money, as they are guaranteed their share in the transaction. For the Islamic banks, however, the profits and losses are shared. The bank, therefore, pays close attention to developing project appraisals and evaluations (Hj Abd Rahman, 2007, p.1). This means therefore that, if the bank did not develop this framework, it would end up making losses in most of its transactions.

For conventional banks, existence is tagged on the ability to make a profit at the expense of everything else. The bank, therefore, is concerned about the creditworthiness of the clients (Hj Abd Rahman, 2007, p.1). The banks provide services to those clients who can afford to pay for them. As opposed to the functioning of the conventional banking system, the Islamic system gives more importance to the viability of the projects that clients are working on and not on their creditworthiness (Hj Abd Rahman, 2007, p.1).

For the traditional banking system, the relationship between a bank and its clients is based on the creditor-debtor relationship (Hj Abd Rahman, 2007, p.1). This means that the relationship is between one who asks for credit and one who is providing the credit. These two parties do not interact on many other grounds if the relationship is respected. For the Islamic banking system, however, the relationship between the two parties is described as a partnership. Therefore, “the status of the Islamic bank about the client is that of partners, investors and traders, and buyers and sellers” (Hj Abd Rahman, 2007, p.1). In the other difference between these two systems, a guarantee has to be made for all the deposits in the conventional/traditional banking system (Hj Abd Rahman, 2007, p.1). According to Hj Abd Rahman however, “an Islamic bank only guarantees deposits for deposit accounts, which are based on the al-with principle. Thus, the depositors are guaranteed repayment of their funds. However, if the account is based on the mudharabah concept, clients have to share a loss position (2007, p.1).

The Islamic banking system considers goods or assets to be the main mode of trade in the fixing of value on transactions. This case is different from the conventional banking system, which views money as the means of trade and interaction with clients. This creates the problem of inflation in the disbursement of funds by a conventional bank since there is an expansion of money during the transactions (Hj Abd Rahman, 2007, p.1). In the Islamic banking system, however, there exist goods and services in their transactions for ensuring that there is little expansion of money (Hj Abd Rahman, 2007, p.1). This means that there is no creation of inflation in Islamic banks’ transactions. However, if it exists, it is not as apparent as the traditional banking system.

Due to the inflation created in the transactions between the conventional banks and their clients who are the entrepreneurs, the price of goods and services increases as a measure by the entrepreneur to ensure profitability and ability to pay back the bank. This is not a characteristic of the Islamic banking system, which ensures the price of commodities and services remains constant. The entrepreneur does not pass the extra charge of inflation to the consumers since inflation is non-existent. The above differences mark the definition of both the traditional and conventional banking systems. The traditional banking system is therefore detached from the needs of the population, which it serves. The Islamic bank however has the interests of the Muslim community at heart.

Conclusion

In conclusion, the above essay looks at the Islamic banking system, its origin, development, characteristics, and principles of practice. This is followed by a thorough comparison between the two systems of banking. Several Islamic countries have Islamized their banking systems as discussed above. A variety of banks in the western world has also been formed to meet the needs of the increasing number of Islamic bankers. As seen above, the rate of growth of the Islamic banks since their inception in the early 70s has continued to surprise many professionals in the field.

The principles, which govern Islamic banking, are those of Sharia law. They include the prohibition of riba or interest on the services and transactions of the institutions. The law also requires the financial institutions as well as individuals to avoid transactions that would earn them money out of luck without having to work for it as represented by interest. The structuring of the Islamic banks is therefore centered on these principles. As discussed above, the principles and practices of Islamic banking are many. Some of them discussed above include Murabahah, Wadiah, Mudharabah, Bai’ Bithaman Ajil, Musyarakah, Ijarah Thumma Bai’, Wakalah, Qard, and Sukuk. These contribute towards making the Islamic bank different from a traditional bank. However, the two financial institutions provide similar ranges of services that are geared towards profit-making.

In the comparison between the two systems, the major limitation for Islamic banks is their respect and following of the Sharia law, which governs their transactions. For the two banks, the original reason for establishment is the need to fill the gap that other institutions create in a bid to satisfy the financial needs of a certain population. For the Islamic bank, this population is defined: as the Muslim faithful. The bank lives up to its purpose since it qualifies as a lifestyle for the society on which it is founded. For the conventional banks, the interests of the bank soon get to them. They start to offer other services that ensure their survival in the market. This may be different and distant from the original reason for the establishment. In the conventional banking system, emphasis is made on clients’ ability to pay back any funds that are accorded to them by the bank. The system ensures that they lend out money based on the interest to be paid by the borrower of the money. The relationship with the client is that of a debtor and a creditor.

Islamic banking has therefore stepped in to fill the gap in the unbanked populations by providing services that are within their belief system. The unprecedented growth of these institutions has led to the traditional banks rolling out the services offered in Islamic banks to maintain a lead in the market by preventing the Muslim account holders from walking out of their hold. This is a significant step in the financial system. It is likely to create competition to the advantage of the clients. This case is likely however to have little effect on the outcome in competition between the two financial systems.

References

Al-Iqtisadiyah, A. (2005). The Total Deposits of Two Hundred and Eighty Islamic Banks in Forty-Eight Countries Reach Four Hundred Billion Dollars. J.KAU Islamic Econ., 19(1), 37-9.

Chachi, A. (2005). Origin and Development of Commercial and Islamic Banking Operations. J.KAU: Islamic Econ., 18(2), 325.

Hasan, K. (1999). Islamic Banking in Theory and Practice: The Experience of Bangladesh. Managerial Finance, 25(9), 60-113.

Hassan, K., & Lewis, M. (2007). Handbook of Islamic banking. Cheltenham, UK: Edward Elgar.

Hj Abd Rahman, U. (2007). Differences Between Islamic Banks & Conventional. Zaharuddin.net. Web.

Iqbal, M., & Molyneux, P. (2005). Thirty Years of Islamic Banking: Theory and Practice. London: John Wiley and Sons Ltd.

Thomas, A. (2006). Interest in Islamic economics understanding riba. London: Routledge.

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UniPapers. "The Islamic Banking: Principles of Practice." June 1, 2022. https://unipapers.org/free-essay-examples/the-islamic-banking-principles-of-practice/.

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UniPapers. 2022. "The Islamic Banking: Principles of Practice." June 1, 2022. https://unipapers.org/free-essay-examples/the-islamic-banking-principles-of-practice/.

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UniPapers. (2022, June 1). The Islamic Banking: Principles of Practice. https://unipapers.org/free-essay-examples/the-islamic-banking-principles-of-practice/

References

UniPapers. (2022) 'The Islamic Banking: Principles of Practice'. 1 June.