How does Islamic banking work?
Historically, the practice of ‘Usura’ - or interest lending - was considered immoral, and was once outlawed by several English kings. The term ‘ursury’ once referred to financial interest of any kind, though it is now commonly used to denote an unreasonably high interest rate which enriches the lender.
The approach taken by mainstream banks towards ethical or responsible banking has varied throughout the years, however. We are familiar with banks offering savings accounts, credit cards, and mortgages with competitive rates of interest.
These financial products tend to conflict with Islamic finance - which is also sometimes known as Shari’ah-compliant finance - in a number of key areas. In particular, these bank accounts do not give or receive interest, in accordance with Shari’ah principles.
History of Islamic banking
The practice of prohibiting interest stems from the Islamic tenet that money is only a medium of exchange; that it has no value in itself, therefore cannot generate more money – either through lending, or earning interest simply sitting in an account. Islamic finance is principally based on trading, therefore banks can profit from the buying and selling of Shari’ah-compliant goods and services.
When customers deposit money, the banks select Shari’ah-compliant investments, then profits and risks are shared with the bank equally. The practices of Islamic banking have some clear ethical advantages over more traditional banking systems, which can be seen as unscrupulous.
How do Islamic banks make a profit?
Despite Islamic banks being prohibited from giving or taking interest, they are able to generate profit through a number of Shari’ah-compliant means:
Ijara is when banks buy an asset, such as a car, and lease it to the customer. Ownership remains with the bank until the lease is paid off by the customer. During this time, the bank is responsible for maintenance of the asset.
Murabaha means the bank acts as an intermediary to buy the asset, which is then sold to the customer, plus profit. The customer buys the asset with deferred payments.
Wakala refers to a contract of agency or delegated authority in which the bank is appointed much like an individual agent to carry out a specific task on the customer’s behalf. The bank lends its expertise for a set duration for an agreed upon profit.
Salam could be considered forward-financing, or as a kind of debt – the institution pays for specified assets in advance, which the seller will then supply to a quality, quantity, and time the parties have pre-agreed.
Ethical banking practices
Shari’ah banks, and other Ethical Banking Systems are commonplace in many countries including the UK, though many conventional banks also offer Shari’ah compliant current accounts. These are also protected under the Financial Services Compensation Scheme in the UK, much like any other account.
Whilst not all ethical banks comply exactly with the banking principles of Islam, there are key similarities in how they operate; many ethically-inclined financial institutions conduct their business according to transparency principles, ensure sustainability, and aim to put customers’ money to productive use by reinvesting their profits in society.
Whilst Islamic banks represent a significant percentage of the banking population, in recent years, other ethical banks also report growing customer numbers and far greater profit per employee.
If you count on your career in banking, or are simply interested in Alternative Banking methods, such as Islamic banking, then look at MA in Finance & Investment (Islamic Banking and Finance) or Dual MSc & MA in Finance & Investment (Islamic Banking and Finance) as a way to invest in your future.
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