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Islamic banking, Islamic finance (Arabic: مصرفية إسلامية masrifiyya 'islamia), or Sharia-compliant finance[1] is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic economics. Some of the modes of Islamic banking/finance include Mudarabah (profit-sharing and loss-bearing), Wadiah (safekeeping), Musharaka (joint venture), Murabahah (cost-plus), and Ijara (leasing).
Sharia prohibits riba, or usury, generally defined as interest paid on all loans of money[2][3] (although some Muslims dispute whether there is a consensus that interest is equivalent to riba).[4][5] Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haram ("sinful and prohibited").[citation needed]
These prohibitions have been applied historically in varying degrees in Muslim countries/communities to prevent un-Islamic practices. In the late 20th century, as part of the revival of Islamic identity,[6][Note 1] a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community.[8][9] Their number and size has grown, so that by 2009, there were over 300 banks and 250 mutual funds around the world complying with Islamic principles,[10] and around $2 trillion was Sharia-compliant by 2014.[11] Sharia-compliant financial institutions represented approximately 1% of total world assets,[12] concentrated in the Gulf Cooperation Council (GCC) countries, Bangladesh, Pakistan, Iran, and Malaysia.[13] Although Islamic banking still makes up only a fraction of the banking assets of Muslims,[14] since its inception it has been growing faster than banking assets as a whole, and is projected to continue to do so.[11][15][16]
The industry[ambiguous] has been lauded[by whom?] for returning to the path of "divine guidance" in rejecting the "political and economic dominance" of the West,[6] and noted as the "most visible mark" of Islamic revivalism,[17] its most enthusiastic advocates promise "no inflation, no unemployment, no exploitation and no poverty" once it is fully implemented.[15][16] However, it has also been criticized for failing to develop profit and loss sharing or more ethical modes of investment promised by early promoters,[18] and instead merely selling banking products[19] that "comply with the formal requirements of Islamic law",[20] but use "ruses and subterfuges to conceal interest",[21] and entail "higher costs, bigger risks"[22] than conventional (ribawi) banks.
Islamic banking and finance
Islamic financial institutions take different forms. They may be
Full-fledged Islamic financial institutions (for example Islami Bank Bangladesh Ltd, Meezan Bank in Pakistan);[201]
Islamic "windows" – i.e. separate, sharia-compliant units[202] – in conventional financial institutions (for example: HSBC – HSBC Amanah, American Express Bank, ANZ Grindlays, BNP-Paribas, Chase Manhattan, UBS, Kleinwort Benson, Commercial Bank of Saudi Arabia, Ahli United Bank Kuwait, Riyad Bank);[201] (Scholars debate compliance of this form, according to Faleel Jamaldeen, "primarily" because of "where" the funds for these windows come from.)[203]
Islamic subsidiaries of conventional financial institutions (for example: Citibank subsidiary Citi Islamic Investment Bank (Bahrain), Union Bank of Switzerland subsidiary Noriba Bank).[201]
Islamic NBFCs or Non Banking Financial Institutions (Like small NBFCs that are operational in India)
Size and locations
Edit
Percentage of world market share of Islamic banking industry by country, 2014[204]
Saudi Arabia 33
Malaysia 15.5
UAE 15.4
Kuwait 10.1
Qatar 8.1
Turkey 5.1
Indonesia 2.5
Bahrain 1.6
Pakistan 1.4
Rest of the world 7.3
Sharia-compliant banking grew at an annual rate of 17.6% between 2009 and 2013, faster than conventional banking,[11] and is estimated to be $2 trillion in size,[11] but at 1% of total world,[11][12][205] still much smaller than the conventional sector.
As of 2010, Islamic financial institutions operate in 105 countries. Statistics differ on which country has the largest Islamic banking sector. According to the 2016 World Islamic Banking Competitiveness Report (see table), Saudi Arabia, Malaysia, United Arab Emirates, Kuwait, Qatar, and Turkey represented over 87% of the international Islamic banking assets.[206] A 2006 report by ISI Analytics also lists Saudi Arabia at the top and Iran as insignificant.[207][69] In Qatar, Islamic banking assets were valued at $97 billion at the end of 2017, accounting for nearly 81% of total Islamic finance assets, according to QFC Authority chief executive officer Yousuf Mohamed al-Jaida.[208] The country also announced the launch of an energy-focused Islamic bank with $10 billion capital in 2019, which would make it the biggest Islamic lender for energy projects in the world.[209]
However, according to Ibrahim Warde, Shia-majority Iran dominates Islamic banking with $345 billion in Islamic assets, Saudi Arabia with $258 billion, Malaysia $142 billion, Kuwait with $118 billion and UAE with $112 billion. Islamic banks in UAE also provides Islamic investment programs which are Shariah compliant.[201][210] And according to Reuters, Iranian banks accounted for "over a third" of the estimated worldwide total of Islamic banking assets, (although sanctions have hurt Iran's banking industry and "its Islamic financial system has evolved in ways that will complicate ties with foreign banks"). According to the latest central bank data, Iran's banking assets as of March 2014 totalled 17,344 trillion riyals or $523 billion at the free market exchange rate.[211][212] According to The Banker, as of November 2015, three out of ten top Islamic banks in the world based on return on assets were Iranian.[213]
PERSONAL FINANCE BANKING
Islamic Banking and Finance Definition: History and Example
By EVAN TARVER Updated June 20, 2023
Reviewed by MARGARET JAMES
Fact checked by SUZANNE KVILHAUG
Islamic Banking: Financial activities that adhere to Shariah (Islamic law).
Investopedia / Jiaqi Zhou
What Is Islamic Banking?
Islamic banking, also referred to as Islamic finance or Shariah-compliant finance, refers to financial activities that adhere to Shariah (Islamic law). Two fundamental principles of Islamic banking are the sharing of profit and loss and the prohibition of the collection and payment of interest by lenders and investors.
KEY TAKEAWAYS
Islamic banking, also referred to as Islamic finance or Shariah-compliant finance, refers to finance or banking activities that adhere to Shariah (Islamic law).
Two fundamental principles of Islamic banking are the sharing of profit and loss and the prohibition of the collection and payment of interest by lenders and investors.
Islamic banks make a profit through equity participation, which requires a borrower to give the bank a share in their profits rather than paying interest.
Some conventional banks have windows or sections that provide designated Islamic banking services to their customers.
How Islamic Banking Practices Work
There are more than 560 banks and over 1,900 mutual funds around the world that comply with Islamic principles. Between 2015 and 2021, Islamic financial assets grew to about $4 trillion from $2.17 trillion and are projected to rise to roughly $5.9 trillion by 2026, according to a 2022 report by the Islamic Corporation for the Development of Private Sector (ICD) and Refinitiv.
1
This growth is largely due to the rising economies of Muslim countries (especially those that have benefited from oil price increases).
Note
The global Islamic finance industry grew in 2021 and 2022 due to increased bond issuance and a continuing economic recovery in the financial markets, according to S&P Global Ratings. Islamic assets also managed to expand over 10% in 2020, despite the pandemic.
2
Islamic banking is grounded in the tenets of the Islamic faith as they relate to commercial transactions. The principles of Islamic banking are derived from the Quran, which is the central religious text of Islam. In Islamic banking, all transactions must comply with Shariah, the legal code of Islam (based on the teachings of the Quran).
3
The rules that govern commercial transactions in Islamic banking are referred to as fiqh al-muamalat.
Employees of institutions that abide by Islamic banking are trusted to not deviate from the fundamental principles of the Quran while they are conducting business. When more information or guidance is necessary, Islamic bankers turn to learned scholars or use independent reasoning based on scholarship and customary practices.
One of the primary differences between conventional banking systems and Islamic banking is that Islamic banking prohibits usury and speculation. Shariah strictly prohibits any form of speculation or gambling, which is referred to as maisir.
4
Shariah also prohibits taking interest on loans. In addition, any investments involving items or substances that are prohibited in the Quran—including alcohol, gambling, and pork—are also prohibited.
5
In this way, Islamic banking can be considered a culturally distinct form of ethical investing.
An Islamic bank is entirely operated using Islamic principles, while an Islamic window refers to services that are based on Islamic principles provided by a conventional bank. Some commercial banks offer Islamic banking services through dedicated windows or sections.
To earn money without the typical practice of charging interest, Islamic banks use equity participation systems. Equity participation means if a bank lends money to a business, the business will pay back the loan without interest and instead give the bank a share in its profits.
If the business defaults or doesn't earn a profit, then the bank also doesn't benefit. In general, Islamic banking institutions tend to be more risk-averse in their investment practices. As a result, they typically avoid business that could be associated with economic bubbles.
History of Islamic Banking
The practices of Islamic banking are usually traced back to businesspeople in the Middle East who started engaging in financial transactions with their European counterparts during the Medieval era.
At first, they used the same financial principles as the Europeans. However, over time, as trading systems developed and European countries started establishing local branches of their banks in the Middle East, some of these banks adopted the local customs of the region where they were newly established, primarily no-interest financial systems that worked on a profit-and-loss sharing method.
By adopting these practices, these European banks could also serve the needs of local businesspeople who were Muslim.
Beginning in the 1960s, Islamic banking resurfaced in the modern world, and since 1975, many new interest-free banks have opened.
6
Though the majority of these Islamic banking institutions were founded in Muslim countries, Islamic banks also opened in Western Europe during the early 1980s. In addition, national interest-free banking systems have been developed by the governments of Iran, Sudan, and (to a lesser extent) Pakistan.
7
Example of Islamic Banking
The Mit-Ghamr Savings Bank, established in 1963 in Egypt, is commonly referred to as the first example of Islamic banking in the modern world. When Mit-Ghamr lent money to businesses, it did so based on a profit-sharing model.
8
The Mit-Ghamr project was closed in 1967 due to political factors, but during its year of operations, the bank exercised a great deal of caution, only approving about 40% of its business loan applications. However, in economically good times, the bank's default ratio was said to be zero.
9
What Is the Basis of Islamic Banking?
Islamic banking is grounded in the tenets of the Islamic faith as they relate to commercial transactions. The principles of Islamic banking are derived from the Quran, the central religious text of Islam. In Islamic banking, all transactions must comply with Shariah, the legal code of Islam based on the teachings of the Quran. The rules that govern commercial transactions in Islamic banking are referred to as fiqh al-muamalat.
How Are Conventional and Islamic Banking Different?
One of the primary differences between conventional banking systems and Islamic banking is that Islamic banking prohibits usury and speculation. Shariah strictly prohibits any form of speculation or gambling, which is referred to as maisir. Shariah also prohibits taking interest on loans. Also, any investments involving items or substances forbidden in the Quran—including alcohol, gambling, and pork—are prohibited.
How Do Islamic Banks Make Money?
To earn money without the typical practice of charging interest, Islamic banks use equity participation systems, which are similar to profit sharing. Equity participation means if a bank lends money to a business, the business will pay back the loan without interest and instead give the bank a share in its profits. If the business defaults or doesn't earn a profit, then the bank also doesn't get paid.
The Bottom Line
Islamic banking is also referred to as Islamic finance or Shariah-compliant finance. It refers to finance or banking activities that comply with Islamic law.
There are many differences between Islamic and mainstream finance, but two of the most important are the methods of sharing profit and loss, and the prohibition of the collection and payment of interest by lenders and investors. Shariah also prohibits taking interest on loans. Islamic banks make a profit through equity participation, which requires a borrower to give the bank a share in their profits, rather than paying interest.
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PART OF
Guide to US Banking Laws
A Primer on Important U.S. Banking Laws1 of 29
Dodd-Frank Act: What It Does, Major Components, and Criticisms2 of 29
Major Regulations Following the 2008 Financial Crisis3 of 29
Too Big to Fail: Definition, History, and Reforms4 of 29
Volcker Rule: Definition, Purpose, How It Works, and Criticism5 of 29
Understanding the Basel III International Regulations6 of 29
What Is Basel I? Definition, History, Benefits, and Criticism7 of 29
Basel II: Definition, Purpose, Regulatory Reforms8 of 29
Basel III: What It Is, Capital Requirements, and Implementation9 of 29
What Basel IV Means for U.S. Banks10 of 29
A Brief History of U.S. Banking Regulation11 of 29
The Evolution of Banking Over Time12 of 29
How the Banking Sector Impacts Our Economy13 of 29
What Agencies Oversee U.S. Financial Institutions?14 of 29
Dual Banking System: Meaning, History, Pros and Cons15 of 29
Glass-Steagall Act of 1933: Definition, Effects, and Repeal16 of 29
Bancassurance17 of 29
Electronic Fund Transfer Act (EFTA): Definition and Requirements18 of 29
Bank Secrecy Act (BSA): Definition, Purpose, and Effects19 of 29
How Banking Works, Types of Banks, and How To Choose the Best Bank for You20 of 29
Chartered Bank: Explanation, History and FAQs21 of 29
Nonbank Financial Institutions: What They Are and How They Work22 of 29
Shadow Banking System: Definition, Examples, and How It Works23 of 29
Islamic Banking and Finance Definition: History and Example24 of 29
What Is Regulation E in Electronic Fund Transfers (EFTs)?25 of 29
What Is Regulation CC? Definition, Purpose and How It Works26 of 29
Regulation DD: What it is, How it Works, FAQ27 of 29
Regulation W: Definition in Banking and When It Applies28 of 29
Deregulation: Definition, History, Effects, and Purpose29 of 29
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