Introduction to Islamic Banking

KGV · 06:07 PM

Of late a lot has been seen in the media about Islamic Banking. What it is all about? How is it different from the conventional banking? What is it that people at HSBC , Standard Chartered and at other banks offering Islamic Banking products tell people about it. Well I tried to guess what they might be telling people. So here is a brief introduction to what Islamic Baking is all about.
Islamic Finance is based on the principles of Shari’ah which prohibit charging interest (riba) from lendee regardless of the purpose for which loans are made and regardless of the rates at which interest is charged. The prohibition of riba is mentioned in four different revelations in the Qur'an.

The first revelation emphasizes that interest deprives wealth of God's blessings. The second revelation condemns it, placing interest in juxtaposition with wrongful appropriation of property belonging to others. The third revelation enjoins Muslims to stay clear of interest for the sake of their own welfare. The fourth revelation establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and to forgo even this sum if the borrower is unable to repay.

The basic logic behind banning of Interest is that when someone is in need of money , one should not exploit him and charge interest but should rather help him out. So interest is banned. Islamic Finance is basically interest free finance. So how does it work?
Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. The owner of capital may 'invest' by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes and he may share the profits, if any, with the entrepreneur- borrower; losses, if any, however, will be borne wholly by the capital owner. So based on these principles islamic banks work as follows.

Loan - (Murabaha) involves the bank purchasing a commodity at the market-value and then selling it to the customer at a higher price than the market-value. Instead of interest in a traditional loan, the bank makes a profit with the difference of the purchase value. Vehicle loan’s are a common sight in Islamic banks around the world. A simple example - you can’t afford a brand new Indica for 5.5 lakhs, so the bank purchases it at 5 and sells it to you at 6. The vehicle is under their ownership until you complete the installments.
Similarly when you open a savings account with the bank, it does not pay you any interest on your deposite but when bank makes profit because of your deposites it shares a part of that profit with you. Some systems allow banks to accept current and savings deposits without having to pay any return, but they permit the banks to offer incentives such as variable prizes or bonuses in cash or kind on these deposits. Term deposits (both short-term and long-term) earn a rate of return based on the bank's profits and on the deposit maturity.

Islamic banking goes beyond the pure financing activities of conventional banks. Islamic banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking. There is a whole lot to it than what is mentioned here in this article but for the sake of simplicity we shall limit ourselves to this part only.

Islamic Banking as the name suggests has its main source from Shariah but it does not necessarily mean that it is strictly for Muslims. It can be considered as an innovative way for financing which encourages entrepreneurship. Both lender as well as lendee come in together as business partners and hence equally share profit or loss from the deal.