WHAT IS ISLAMIC BANKING?
In our previous articles, we covered the principles of Islamic banking and Finance at length but haven’t explained what Islamic banking is.
Islamic Banking is simply a mode of banking that is done in an Islamic way or banking that adheres to Islamic principles that are derived from the Shari’ah law.
Banks as we know them traditionally are financial institution that deal in financial intermediation who collect deposit from those with excess funds and lend to those who want to borrow.
In conventional banking, the relationship between the bank and the customer is lender borrower relationship. The return that is obtained from this kind of transaction is interest which is prohibited in Shari’ah Law.
Shariah calls for elimination of riba (interest), Gharar (uncertainty), use of asset backed instruments in financing and the application of profit and loss sharing model in financial transactions.
While the aforementioned principles were used in earlier times, it is only in the late 20th century that banks were formed to provide an alternative form of banking based on the principles.
The foremost source of Shari’ah is the Qur’an followed by recorded sayings and actions of Prophet Muhammad ﷺ (Hadith). Where guidance cannot be found in the two sources, rulings are made based on the consensus scholars, independent reasoning of an Islamic scholar and custom.
Islamic finance was practiced predominantly in the Muslim world throughout the middle ages. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen. In Spain, the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities.
The revival of Islamic banking in 1960s and 1970s was as a result of dissatisfaction with the value neutral capitalist and socialist financial systems as well as religious convictions which led not only Muslims but also others to look for ethical values in their financial dealings.
Birth of Modern Islamic Banking
The origin of the modern Islamic banking can be traced back to pre-Islamic era where the Prophet ﷺ himself acted as an agent for his wife’s trading operations through Mudaraba and or Wakala contracts years before getting the prophethood.
Mudaraba was very prominent during early days where the concept of interest found very little application in day-to-day transactions. Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person.
The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour.
Modern Islamic banking system was built by simply incorporating the transactions used during the time of Prophet Muhammad ﷺ and applying them to the present financial institutions.
Be it conventional banks, investment banks, Societies, Venture entities or micr finance banks, so long as they adopt these principles in totality then they are deemed to be Shari’ah Compliant financial institutions.
Islamic banking has the same purpose of financial intermediation as conventional banking except that it operates in accordance with the rules of Shari’ah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking activities must be practiced consistent with the Shari’ah.
