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.
In the 19th century, number of religious scholars argued that the term Riba only referred to loans for personal consumption and not to loan extended to traders who repay both principle and interest from the profits realized from the trade.
However, Qur’an makes no distinction between loans for consumption and loans for productive purposes provided that it is a lender borrower relationship then any additional amounts paid are deemed to be Riba. So their views were rejected.
Consequently, modern commercial banking did not make much headway in Muslim countries and to this day the presence of the conventional framework still dominates the national financial systems in number of Muslim majority countries.
Today Islamic banking are practiced either as “Windows”, fully fledged Banks, Branches or Subsidiaries in order to meet the increased need of financial services by Muslims who are cautious of Riba in their dealings.
Islamic Banking and Finance in the 20th-21st Century
The modern Islamic Banking in an institution form was first implemented in 1963, in Mit Ghamr, Egypt, the first Islamic interest-free bank came into being as a social bank. Mit Ghamr was a rural area and the people were religious. They did not place their savings in any bank, knowing that interest was forbidden in Islam.
In these circumstances, the task was not only to respect Islamic values concerning interest, but also to educate the people about the use of banking. In addition, the bank set up savings accounts, Investment Accounts and Zakat Accounts. Small, short-term, interest-free loans for productive purposes could be made. Funds in investment accounts were subject to restricted withdrawals and invested on the basis of profit- sharing. The zakat account attracted the official amount of zakat of 2.5% as per the religious scriptures.
The Mit Ghamr project was successful, as indicated by the number of customers and the deposit. The bank was cautious, rejecting about 60% of loan applications and the default ratio was zero in economically good times.
The project was eventually abandoned for political reasons. 1972, the Mit Ghamr Savings project became part of Nasr Social Bank.
The project had shown that commercial banking could be organised on a non-interest basis. It is on this successful premise other Islamic financial institutions sprung up. The increase in petro dollars also assisted a great deal for the growth of the Islamic banking and finance sector.
In 1975 the Islamic Development Bank was set up with the mission to provide funding to projects in the member countries. Dubai also established a modern Islamic bank dubbed Dubai Islamic Bank in 1979, later on in Malaysia, Sudan, Pakistan, Europe in UK and America.
Today Islamic Banking can globally boost of over $2trillion worth of Shari’ah compliant investments which is on an upward trajectory.