Banking on Sharia Principles: Islamic Banking and the Financial Industry

Dr. Linda Eagle

There are an estimated 1.61 billion Muslims worldwide, making Islamic banking one of the fastest growing
segments of the financial industry. Banks serving the Islamic population must comply with several very
specific principles of Islamic law if they hope to retain existing customers and attract new ones. Banks
must be ready with specialized products and services and they must put programs in place to train their
personnel to support these products and services in order to exist in this competitive marketplace.

The basic principle of Islamic banking follows the laws of Sharia, known as Fiqh al-Muamalat (Islamic
rules on transaction). The term “Islamic banking” is synonymous with “full-reserve banking” and “Sharia-
compliant banking.” The most prominent feature of these laws is usury – the prohibition of paying or
collecting interest on funds. The Islamic terminology for this is riba or ribaa. The Sharia also forbids
engagement in investments that include financial unknowns such as buying and selling futures, as well as
businesses that are haraam – dealing in products that are contrary to Islamic law and values such as
alcohol, pork, gossip or pornography. These principles apply to all individuals, companies and
governments.

Banks that comply with Islamic law are forbidden to charge interest or late payment fees, which is also
considered a type of riba. To minimize risk, banks will often require a large down payment on goods and
property, or insist upon large collateral. It is lawful for the Bank to charge a higher price for a good if
payments are deferred or collected at a later date since it is considered a trade for goods rather than
collecting interest. Sharia-compliant banking products include Mudharabah (profit sharing), Wadiah
(safekeeping), Musharakah (joint venture), Murabahah (cost plus) and Ijarah (leasing). Another way that
banks work within Islamic laws while trying to turn a profit is by buying an item that the customer wants,
and then selling the item to the customer at a higher price.

The Mudharabah is a partnership between an entrepreneur and the bank. The bank is known as the
rabal-maal and the entrepreneur as the mudarib. The bank provides all of the necessary capital to start a
business and the entrepreneur does the work of managing the business. Profits are split at an agreed
ratio until the initial funds of the rabal-maal are paid off. The rabal-maal is also compensated with
additional funds based on the profits of the business in terms previously agreed on. In the event that the
business folds, the rabal-maal shoulders the cost and the mudarib is not compensated.

Musharakah is similar to Mudharabah, in which an entrepreneur seeks funds for a business venture and
pays the bank back with a ratio of profits. However, there are often more than two parties who contribute
funds and become partners who can influence the business depending on the amount of money invested.
The entrepreneur also contributes funds and shares in the risk. Any loss is proportional to the amount of
capital invested in the business.

Wadiah is a system in which a person deposits money into a bank and receives a “gift” from the bank.
The bank is the keeper of the funds and will refund the entire amount at the demand of the depositor. The
bank rewards the amount of time the depositor keeps the money in the bank with a hibah or gift, which is
not guaranteed. The hibah is similar to interest, but lawful according the Islamic law.

Murabaha governs the issuing of home loans or any other type of goods needed by a borrower. An
Islamic bank does not lend money to a borrower to buy properties; rather, the bank will purchase the
property at the borrower’s request at a freely disclosed price, and mark up the price for the borrower to
pay back, therefore making a profit from the investment. The borrower is named on the title and allowed
to utilize the property immediately and pays the bank back in installments.

Another type of loan is the Ijara, in which the bank buys the home or item and leases the property to the
borrower while retaining ownership of the property. The borrower can either use the property for a pre-
determined period of time, or pay off the purchase price and buy out the Bank to attain full ownership of
the property.

There are occasionally controversies surrounding the interpretation of the riba, which certain scholars
argue was meant to prevent petty money-lenders from abusing borrowers, rather than a modern bank
charging a reasonable, agreed upon interest. The general consensus, however, is that any interest is a
direct violation of the law of Sharia and therefore unethical.

While each Islamic bank has its own board which rules on ethical banking principals, Islamic banking
organizations have been establishing standard regulations and policies. The Islamic Development Bank
has been working on international standards, policies and procedures, and the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI), Islamic Finance Service Board (IFSB),
International Islamic Financial Market, Liquidity Management Center and International Islamic Rating
Agency are in development to ensure accurate and fair banking practices.

Today, Islamic financial institutions exist worldwide, participating in the $180 billion/day industry. In 1975
there was one Islamic bank; today there are over 300 in more than 75 countries. Islamic banks have
become more prevalent worldwide and can be found in high numbers in such countries as Indonesia,
Pakistan, Bangladesh, Nigeria, Egypt, Turkey, Iran, Sudan, Algeria, Morocco, Iraq, Uzbekistan,
Afghanistan, Malaysia, Saudi Arabia, Yemen, Syria and Kazakhstan. The total amount of deposits in
Islamic institutions, balance sheets, assets under management and private wealth are growing at a rate of
25-40% annually. Because oil prices and liquidity are expected to stay at the same levels throughout
2007, budget surpluses will remain high, pushing both public and private sectors to be involved with the
Islamic market. Many Islamic countries are investing in large infrastructure projects, creating more than a
trillion dollars in investments. There is also a huge potential customer base. According to Standard and
Poor’s surveys, 20% of the customers in the [Persian] Gulf Area and Southeast Asia would choose an
Islamic banking product over a similar conventional product. There are significant middle-class urban and
suburban populations that already use conventional banking, and therefore present ripe opportunities for
Islamic banks. Most important to note, outside of the religious and political allure of Islamic banks, is that
people are choosing their services for the safeties they offer. The evidence is clear: Islamic banking is big
business and it is growing every day.

However, in order for Islamic banks to be competitive with conventional products and attractive to
customers, Islamic financial products must meet the risk/reward profiles of investors and issuers while
fulfilling the tenets of the Sharia and remaining sufficiently cost-effective. Additionally, Islamic banks must
educate their personnel to understand the tenets of Islamic law that pertain to banking, and to train them
to comply with Sharia as they serve their Islamic customer population.

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