A Laymans Guide to Islamic Banking

Have you heard of the term Islamic Banking? The concept of Islamic Banking is becoming more and more popular in India where there is a significant % of Muslim population. The concept is already prevalent in the Gulf and many south-east Asian countries where high concentration of Muslim populations live in. This article is not an everything you want to know guide of Islamic Banking. Instead, it is a high level - layman’s guide kind of article to help you understand the basics of Islamic Banking.

So, What is Islamic Banking?

Islamic banking is banking or banking activity that is consistent with the principles of sharia. Sharia prohibits the fixed or floating payment or acceptance of specific interest or fees (known as riba) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also haraam ("sinful and prohibited").

Simply put, an Islamic Bank is just like a regular bank, it will give you banking services like bank accounts, deposits etc. but the banks operating principles will be consistent with the Islamic Sharia laws. The bank will not give or take Interest.

So, is an Islamic Bank - a Non-Profit Organization?

No, Absolutely Not.

For the Islamic Bank, providing Islamic Banking services is a business and their aim is to make a profit by conducting this business. However, they conduct their business in accordance to sharia laws.

If they won’t give or take interest, how will they give loans?

Simple, Islamic Banks do not give out loans. They use a buy and sell mechanism.

Example:

Let us say, you want to buy a car. As you are a devout Muslim, you do not want to take an auto loan where the regular bank will charge you an interest. So, you approach the ABC Islamic Bank of India. They ask you for details like, what car you want, what make & model, where you want to buy etc. Then they will verify your identity, income requirements etc. (like any other bank).

Once they verify that you can indeed repay the money, they will go ahead and buy the car themselves. Once they buy it, they will sell it to you for a higher price which will include their profit share. You on the other hand will take the car home and repay the bank in easy instalments. This way, you are only repaying the money you owe the bank. There is no interest paid out by you.

Get the picture??

The same is the case with Home loans as well.

As, the Islamic bank indulges in buying and selling at a higher price method in order to grant its customers loans, it does not give out any non-collateralized loan. Unless there is an entity that the bank can physically own and then re-sell to its customer, the concept of buy and sell will not exist and hence, the repayment may be considered an interest. So, most Islamic banks do not give out non-collateralized loans.

So, what happens if I default on my Payments?

Until you finish repaying all your monthly instalments, the bank has the right to take possession of the car/home. So, in case you default, the bank will take possession of your car or house and liquidate it to cover its losses.


Do, Islamic Banks offer Interest on Bank Accounts & Deposits?

Yes and No.

Islamic Banks do not make periodic fixed interest payments like regular banks because; they cannot collect interest from customers. However, they are going to use your deposit money to engage in the buy and sell activity as explained above. So, they are morally bound to share a % of their profit with you. At the end of each financial year, the bank will consolidate its statements and based on the profit they make, they will declare a profit share to their deposit customers. This amount may not be fixed like regular banks. In a year where the bank did incredibly well, the % share could be high and if the bank did terribly this year, they may not share anything at all...



Today, Islamic banking still accounts for only a tiny fraction of the global banking industry. The amount of money held in Islamic banks totals to less than 1 % of global financial assets. But in many countries Islamic banking is growing rapidly and this number can be expected to grow in the near future.

Hope you found this introduction to Islamic Banking interesting and useful...


Happy Banking!!!