Islamic Banking

Islamic banking operates in accordance with Islamic principles, which absolutely ban the payment or receipt of interest. Islamic principles also prohibit banks from furnishing capital to firms providing immoral goods and services, such as pornography. Compliance with prohibitions against interest in financial transactions is the core difference between Islamic banks and their Western counterparts. For the purpose of banking and finance, the key point in Islamic principles is that paying or receiving interest is forbidden, but earning profits is permissible. A fixed or predetermined rate of return represented by interest violates Islamic principles, but an uncertain rate of return represented by profits raises no ethical issues under Islam. The growth of Islamic banking began to gain momentum in the last half of the 1970s as oil revenue began flowing into the Middle East.

Forms of Islamic banks can vary between countries but follow a general line. These banks hold two forms of deposits, transactions deposits and investment deposits. The transactions deposits bear a strong resemblance to the demand deposits held by Western commercial banks. These deposits earn no interest and act as a medium of exchange. The bank guarantees the nominal value of the deposit against loses. Investment deposits provide the bulk of the Islamic banks’ funds. These funds do not pay interest or a fixed rate of return, and the bank does not guarantee the nominal value of these funds. Investment deposits bear a stronger resemblance to Western style shares of corporate stock than to the time and savings deposits of Western banks. Like shareholders, investment depositors receive a share of the profit and losses earned by the bank. The bank only guarantees that the profits and losses will be distributed between the bank and a depositor in a certain proportion. The proportion cannot be changed during the life of a contract.

Islamic banks finance business activity by acquiring profit-sharing assets. Rather than pay interest, an entrepreneur promises to pay the bank a predetermined share of the profits. The bank bears all the financial loss in the case of unprofitable ventures. Large and longterm ventures usually involve more than one financial contributor. A predetermined share of the profits are distributed to the various contributors according to the relative size of their respective contributions. This system works similar to an equity market in Western capitalism in that shares in an investment project can be acquired by the public, banks, central banks, or the government.

In financial arrangements where there are no profits to be shared, Islamic banks have other methods. Zero return loans can be made to individuals. On these loans, the bank can charge an administrative fee as long as the fee is a fixed amount and does not vary with the value or length of the loan. In the case of installment purchases, the bank can buy a product on the borrower’s behalf, and sell it to the borrower at a higher price.

The borrower pays a higher price but can pay the higher price out in an installment plan. Some contracts are set up as lease-purchase agreements, in which the bank leases the product to the borrower. Part of each lease payment goes toward final purchase of the good when the lease expires. Manufacturers and farmers borrow working capital by selling the finished product or commodity to the bank, with the condition that the bank will take delivery at some specified date in the future, perhaps at the end of harvest season.