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An Introduction to Islamic or Shariah Compliant Banking

Recently, there has been a lot of discussion in the media about Islamic Banking. This article explains what Islamic or Shariah Compliant banking is, how it works, and what are the products offered through it.



How do banks work?

If the basic operation of banks has to be described, it can be defined in three lines like this:

- Banks collect money from people in the form of deposits and pay them an interest on it.

- Banks lend this money to other people or companies, and charge an interest on it.

- Banks charge more interest on money lent than the interest they give on the money borrowed, and thus, they make a profit.

Islam and Banking

Islam prohibits usury – giving and taking any form of interest (also known as Riba).

In our 3-line, simplistic definition of the operation of banks, each of the three lines talks about interest!

Banks thrive on interest, whereas Islam prohibits interest. This creates a dilemma for traditional Muslims who want to obey the tenets of the holy Quran, but still want to work with banks.

Is there a way out? Can banks work without giving or charging interest?

Enter Islamic Banking!


Islamic or Shariah Compliant Banking

Banks have identified a tremendous customer base in traditional Muslims who want to obey the holy Quran. Therefore, they have come up with products that follow the tenets of Islamic law, but still offer the benefits of traditional products.

The interest component is circumvented using different creative techniques (explained later) to create interest-free (or, riba-free) transactions. And although some people might not be fully satisfied with them, these products do satisfy the Islamic principles – at least in letter, if not in spirit.

Let’s see the methods using which products that follow the Shariah (or Shariat) code are offered.

Murabaha

This is a concept of Cost-Plus, or Profit Making.

Here, the bank purchases an asset at market price, and sells it to the customer at a higher price. The customer pays this amount as installments.

The difference between the bank’s purchase price and the selling price is its profit. The bank remains the owner of the asset till all installments are paid by the customer.

For example, the bank purchases a property for Rs. 15 Lakhs, and sells it to the customer at Rs. 20 Lakhs. The customer would pay this amount back to the bank over, say, 10 years in Rs. 16,667 a month installments.

The Murabaha instrument is usually used in asset financing and property transactions.

How does it compare with non-Islamic products?

Normally, banks give a loan for the market price of the asset, and the customers pay back in installments which includes interest.

In Murabaha, instead of interest, the bank earns a “profit” while selling the asset to the customer.

Thus, in our example, instead of getting an interest of Rs. 5 Lakhs over 10 years (traditional banks), the Islamic bank would earn a profit of Rs. 5 Lakhs.

The same end is achieved using different means!


Mudarabah / Mudharabah

This is a concept of Profit Sharing.

Here, a bank gives money to an entrepreneur to start or run a business, and shares a portion of the profit. The profit sharing ratio is pre-decided.

If there is a loss, the bank doesn’t get a share of its profit.

The sharing of profit continues till the loan is fully paid back.

How does it compare with non-Islamic products?

Normally, banks charge an interest on amount lent. This, banks would get the fixed interest amount irrespective of the level of profit earned by the business.

In Islamic banking, instead of charging a fixed interest, a share in profit is earned in return of the amount provided for running the business.

This is equivalent to the bank getting a floating rate of interest that is pegged not to the prevailing interest rates, but instead, is pegged to the customer’s profits!

Sukuk

These are instruments equivalent to bonds in non-Islamic banking.

Here, the issuer of the sukuk sells the certificate to an investor. The investor then rents it to the issuer for a predetermined fee. This fee is a periodic fee. The issuer has a contractual obligation to buy back the sukuk at a pre-determined date at par value.

How does it compare with non-Islamic products?

The investor “renting” the sukuk instrument and the issuer giving a “rent” is equivalent to the periodic interest received in traditional bonds.

The issuer buying back the sukuk is equivalent to regular bond redemption.


Others

These are just some of the Islamic banking principles to give you a flavour of the Shariah-compliant products offered worldwide.

There are many more available, like Ijarah, Salam, Istisna, Tawarruq, Qardhul Hassan, etc.

Treatment of Penalties / Late Payment Charges

In Shariah-compliant banking, banks are allowed to impose penalties or late payment charges only if the bank agrees to donate money collected this way to charity.

Islamic / Shariah-Compliant Banking in India

Although hugely popular in the middle-eastern Arab nations, and even in the west, Islamic banking is not very wide-spread in India.

In India, it is limited to some co-operative banks and non-banking financial corporations (NBFC).

The Raghuram Rajan committee (which has been set up by the Planning Commission of India to look into financial sector reforms) is also looking at Islamic banking, and is expected to present a favourable recommendation regarding Shariah-compliant banking.

The committee is expected to submit its report in mid-September 2008.

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