Islamic banking and finance

Housing Bank and Islamic Bank Amman

Kuala Lumpur Malaysia Wisma-Tun-Sambanthan-01

Sabaibdjib

IDB Dhaka

KotaKinabalu Sabah BankSimpananNasional-01

Islamic Banking and Finance refers to a system of banking or financing that is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called "riba" in Islamic discourse. Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to prevent such practices. Instead, the Islamic banking and finance industry uses various concepts such as profit sharing (Mudarabah), safekeeping (Wadi'ah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).

Principles of Islamic Banking and Finance

Islamic banking and finance operate on the following key principles:

• Prohibition of Interest (Riba): The most fundamental principle is the prohibition of riba in all financial transactions. This principle is derived from the Quran and the Hadith, and it distinguishes Islamic banking and finance from its conventional counterparts.

• Risk Sharing: Financial transactions should be based on sharing the risk of investment between the lender and the borrower, rather than transferring the risk to only one party.

• Asset-Backing: Islamic finance requires that all financial transactions must be backed by tangible assets. This means that money cannot be made from money; there must be a real underlying economic activity.

• Ethical and Social Considerations: Islamic banking and finance also place a strong emphasis on ethical and social considerations. Investments in businesses that provide goods or services considered contrary to Islamic principles (e.g., alcohol, gambling) are prohibited.

Key Financial Instruments

• Mudarabah (Profit Sharing): A partnership where one party provides the capital while the other provides expertise and management. Profits are shared as per the agreement, but loss is borne only by the provider of the capital.

• Musharakah (Joint Venture): An agreement between two or more parties to pool their resources to set up a business and share its profits and losses in accordance with their contributions.

• Murabahah (Cost Plus): A sales contract where the seller discloses the cost and profit margin to the buyer. It is a common financing method used by Islamic banks.

• Ijarah (Leasing): The leasing of assets, where the lessor (owner of the asset) leases it to a lessee (user) for a fixed rental payment. The ownership of the asset remains with the lessor.

• Sukuk (Islamic Bonds): Financial certificates that represent a proportionate interest in an underlying asset, which are leased or sold to raise funds. Sukuk structures are designed to comply with Islamic law, which prohibits the charging of interest.

Regulatory and Governance Framework

The development of Islamic banking and finance has been accompanied by the establishment of regulatory bodies and frameworks to ensure compliance with Sharia principles. These include:

• Sharia Boards: Each Islamic financial institution typically has a Sharia board composed of Islamic scholars who oversee the institution's adherence to Islamic laws and principles.

• Centralized Sharia Boards: Some countries have established centralized Sharia boards that oversee the Islamic banking and finance industry as a whole.

• Standard-Setting Bodies: Organizations such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) develop standards and regulations for the industry.

Global Reach and Challenges

Islamic banking and finance have seen significant growth over the past few decades, expanding its presence not only in Muslim-majority countries but also in Western markets. However, the industry faces challenges such as the standardization of products and practices, integration with global financial markets, and the development of a comprehensive regulatory framework.