A Beginner’s Guide to Islamic Banking

Islamic Banking

Islamic banking is a confusing concept for people unfamiliar with Muslim culture. At face value, a bank that doesn’t take interest on loans looks inconceivable. However, several principles guide Islamic banking, which makes it a sustainable and profitable institution. Here is a beginner’s guide to Islamic Banking.

What is Islamic banking?

Also known as Shariah-compliant finance or Islamic finance, Islamic banking is a system of finance that follows Islamic laws, the Shariah. The entire system follows two fundamental principles; profits and losses are shared, and the collection of interest from debtors is prohibited. Therefore, how do Islamic banks make their profits?

Islamic banks take a share of the profits from a business instead of receiving an interest payment on a loan. This is called equity participation. As a testament to equity participation, Islamic financial assets increased between 2012 and 2019 from 1.7 trillion dollars to 2.8. Currently, the projections are at 3.4 trillion dollars by 2023.

There are over 500 banks and 1,700 mutual funds around the world that comply with Islamic principles. The number is growing, and more non-muslim are banking with Islamic banks. As a result, the banks’ geographic distribution and services have extended beyond religious lines.

The Rules

The rules that guide transactions in Islamic banking are called fiqh al-muamalat. They are provided in the Quran. However, when specific guidance is needed on particular transactions, and there is no clarity from the Quran, Islamic bankers consult learned scholars. Moreover, bankers can use independent reasoning based on customs and precedence from different scholars.

Islamic banking also prohibits usury and speculation. Any form of speculation or gambling, referred to as maisir, is prohibited by Shariah. Moreover, Islamic rules prohibit investments in certain substances like alcohol and pork. These are considered sinful, haram.

The History

The practices in Islamic banking trace back to the Medieval era when businessmen from the Middle East engaged in financial transactions with Europeans. Initially, their transactions followed European principles. However, the banks had to adopt the people’s cultural practices to serve the local businessmen in the Middle East. As a result, Islamic banking was birthed.

In the 1960s, Islamic banking became popular as more banks opened and their branches spread. Most of the growth was seen in Muslim nations, but interest-free banks also grew in the west.

Mit-Ghamr Savings Bank is the first Islamic established in the modern world. They started operations in 1963 before closure in 1967 due to political factors. However, during the years of operation, the bank saw many successes. They approved 40% of their business loans and saw low default rates. Currently, the largest Islamic bank is Al Rajhi Bank which is based in Saudi Arabia. The bank’s assets total approximately 97.3 billion dollars. Moreover, that bank ranks in the top fifteen banks in the world in terms of market capitalisation.

The Benefits of Islamic banking

Banking with an Islamic bank has its advantages. Here are a few:

Justice and fairness

Islamic banking guarantees equitable distribution of wealth since any risk is shared between the bank and the customer through the profit-sharing principle.


The hallmark of Islamic banking is the transaction of business transparently and fairly. The bankers are keen to guide customers on the risks and costs of their services and products.

Ethical consideration

While some banks don’t get into the ethical details of your business before approving a loan, Islamic banks make all ethical considerations. As a result, finance options are solely approved for socially desirable investments in keeping with fiqh al-muamalat, the principles of Islamic banking.

Open membership

Although many assume Islamic banks are reserved for Muslims, the establishment is open to everyone. Therefore, a non-muslim can bank with an Islamic bank and enjoy similar services and benefits as any other client.

No speculation

Speculative transactions have caused numerous banks to make losses or collapse. Speculation leads to the misallocation of funds and instability. Fortunately, Islamic banks prohibit speculation and encourage capital investment into the real economy. As a result, the client’s money is more secure.

Islamic banking has a few minor drawbacks. For example;

Dilution of control

Equity participation allows the bank to get involved in the ownership and decision-making process of a business taking a loan. As a result, control powers are diluted. Many business owners would rather pay interest on a loan than give up any control of their company.

It’s not for every business

Islamic banks cannot provide credit to particular business ventures that are considered unethical. Examples include pork farming, alcohol, tobacco, the manufacture of ammunition, and adult entertainment. Therefore, some businesses can’t access credit despite their legitimacy.

Profit maximisation

Many investors would opt for credit payments instead of equity participation since the former doesn’t involve sharing risk, and the profits are higher. As a result, Islamic banking doesn’t receive as many investors as standard banks.

Islamic banking is a unique system; however, it has its benefits. It may meet your banking needs and offer the credit services you seek. Therefore, it’s worth consideration.

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