The main purpose of every religion is to fill the ethical value in its believer
that is also about the Islam. Islam considers everyone equal either he is king
or a laborer. This is the reason that Islam prohibits all that ways which is
against the equality and also against the fraternity of the society. In today’s
scenario interest is a burden upon the loan takers. Islamic banking introduces a
concept of interest free banking.
Because not only in Islam but interest is also
not allowed in Christianity, Jewish religions. According to principles of Islam
nobody can take benefit from the difficulties of others. Islamic banks have
different products as compared to conventional banks like murabah, mudhrabah,
musharakah, ijarah, salam etc.
Islamic banks work on the principles of
profit-sharing basis. For instance, if anyone wants to take a loan from the
Islamic banks for any project the bank will not charge interest but enter into a
contract with client and fix the share in profit but if the project fails then
client will not compensate the banks. Also, such banks do not invest in alcohol,
pornography, gambling etc.
After the establishment of first Islamic bank in Dubai and also Islamic
development bank in 1975, Islamic banking movement spread all over the world.
Islamic banks have its existence in many Middle East countries. Malaysia
performed the prominent rule in the movement of Islamic banking. Islamic banks
performed excellent even in the economic crisis of 2008, which is why many
non-Muslim countries are attracted towards it.
However, there are various
challenges towards the smooth working of this banking system which is mentioned
here in the essay. Many steps have been taken and have still to be taken in this
regard to wipe all the challenges. According to the present scenario, the next
few years are going to be tough in this regard and may face many other technical
and regulatory difficulties.
O’mankind eat of which is lawful and wholesome in the earth, and follow not
the footsteps of devil. Lo! He is an open of you.
Islam is total way of life. It regulates not only religious field but also the
social, cultural, political, economic life of its believers. The principles
which emphasize moral and ethical values in all dealing have wide universal
appeal. Islamic banking has the same purpose as conventional banking except that
it operated in accordance with the rules of sharia known as ‘fiqh-ul-muamlat’
(Islamic rules in the transaction).
Islam categorically prohibits the interest-based transaction with the view that
it is against the fraternity of society. No one can gain that benefit to which
he did not work.
Quran states that all treasure of the world cannot purchase the love between
This orders of prohibition of interest lead to introduce a very new and
different financial system to the world, that was based on the sharia principles
and was against the interest based western financial system.
Sources of rules of Islamic banks
Islamic banks based upon the shariah and Sariah is the collaboration of teaching
of Quran and the saying and actions of prophet Muhammad-the hadith.
Where the solution cannot be found in these two sources, rulings are made with
the consensus of a community learned Islamic scholar and custom but this should
not be out from Quran.
Origin of Islamic banking
Islamic banking is not the origin of modern times, but Islamic finance is old as
the religion itself. It has not only principles of before 1400, but it’s some
principles are from the time of Abrahamic tradition.
The origin of Islamic banking dates back to the beginning of Islam in
7th century. The Prophet Muhammad’s wife Khadija was a merchant. He acted as an
agent for her business, using many of the same principles used in contemporary
to Islamic banking.(1) After the arrival of Islam, this form of ethical banking
and finance was also existed in the time of Caliph era.
In the Islamic Golden age, when Islamic world established the relations with
Europe, Muslim merchants practiced the business with Europe especially like the
country Spain. Also, they engaged to follow shariah principles transaction
during that time. Ethical and interest free transactions attracted the local
people of those European countries and they also adopted profit and loss sharing
Modern Islamic economics emerged amongst Indian Muslims in the 1930’s as the
country’s Muslim minority feared an independent and Hindu dominated India would
subject them to hostility and discrimination.(2) Later, a movement of banking in
Pakistan gained prominence in 1950’s a bank established to give loan without
charging interest. But this idea did not succeed due to run out of deposits and
lack of trained staff.
By following this idea, Ahmad-el-Nagar opened a Mit ghamar saving project in
Egypt which gave the interest free banking facilities at the local level, which
was based on sharia principles. This bank was a success and led to founding of
the Nasser social bank in 1971. The success of these Islamic banks attracted and
inspired the Muslim countries.
Dubai was the first country where in 1979, Dubai Islamic bank was established.
In Asia, Malaysia played the prominent role in the establishment and regulation
of Islamic banks. Before the establishment of the first Islamic bank, Malaysia
had a financial institution, which was for the deposit facility to pilgrims for
Haj. This later renamed Tabung Hajj and it eventually led to the bank Islam
What is Islamic banking?
Such banking practice which is based upon the principles of Islam and follows
the sayings of Islam. Banking is all about finance, its major role is to grant
loan on interest but Islam prohibits interest. According to Islam, God has
permitted trade, but forbidden Riba (interest). (2:275). As per this saying,
Islam actually prohibits the interest-based banking and permits only ‘profit
sharing based banking’.
The concept of Islamic finance actually came in 1963 in
Malaysia but the Islam’s holy book itself mentions about this. Islamic banking
is different from the traditional banking in all aspects. The returns for the
banks are guaranteed through the assets purchased with your money.
Sharia identifies three major prohibitions associated with finance, which are as
- Riba is the predetermined interest collected by the lender, it is
received over and above the principal amount lent out. According to Islam
collection of Riba is an unfair technique for all lender, borrower and the
economy. Riba can result in inefficient allocation of available resources in the
economy and may contribute to the instability of the system. In an
interest-based economy, capital is directed to the borrower with the highest
- Gharar (uncertainity) is defined as sale of a probable item whose
existence or characteristics are not certain. An example in the context of
Islamic finance is to advise a customer to buy shares in a company that it is
the subject of a takeover bid on the grounds that the share price is likely to
increaser. Gharar does not apply to business risk such as investing in a
- Maysir (speculation) is a situation where there is a possibility of
total loss for one party. Maysir has elements of gharar, but not every gharar is
The major characteristic of such type of banks is that they prohibit the use of
its funds for various purposes like Alcohol, gambling, weapons, adult
entertainment like pornography which are socially unethical practices and
prohibited under the provisions of Islam.
As of today, Islamic banks does not mean merely a lending institution, but it is
a package of shariah-complaint financial services like Islamic mutual funds,
Islamic bonds, Islamic insurance, Islamic credit cards etc. the two categories
of financing are:
These are the products of Islamic banking which can be explained as:
1. Profit and loss sharing
- Profit & loss sharing, also called participatory modes, i.e. musharakah
- Purchase and hire of goods or assets and services on a fixed return
basis i.e murabaha, istina, salam, ijarah.(3)
- Mushrakah- Musharakah means shurkah (participation). This is a type of
partnership which is also called ‘shurkah-ak-mutanaqisah’.
In this type of partnership, a financer and a client enters into a contract
where financer purchase the ownership of property or other which that client
wants to purchase. After purchase, the share of the property is divided into
units, and client purchase those all units one by one, until he becomes the sole
owner of that property on other thing as the case may be. This is mainly a means
to purchase the property by someone.
- Mudarabah- In this type of contract one partner gives the finance and the
other partner uses his expertise and service. The investor is
called ‘rab-ul-mal’ and the working partner is known as ‘mudarib’ and investment
is known as ‘Rasul-Ul-Maal’.
Mudarabah is also of two types:
# Mudarabah Mutlaq- where there are no restrictions from the investor.
# Mudarabah Muqayyadd- where some restrictions are imposed from the investor.
In such type of partnership, they pre decide the distribution of profit ratio
but if any loss occurs than there will be no compensation from mudarib and rub-ul-mall
will bear all the loss.
2. Purchase and hire of good on assets and services on a fixed return
- Murabaha – In this type of contract, the client petitions the bank to
purchase an item for him/her. Complying with the client’s request, the bank
establishes a contract setting the cost and profit for the item, with repayment
typically in installments. Because a set fee is charged rather than Riba
(interest), this type of loan is legal in Islamic countries.
However, many argues that this is simply another method of charging interest.
- Ishtina – Ishtina is generally a long-term contract whereby a party
undertakes to manufacture, build on contract assets, with an obligation from the
manufacturer to deliver them to the customer upon completion. (4)
- Salam – in the pre-Islamic era, farmers used to take interest-based loan
for growing crop and harvesting. But when Islam prohibits it, them Salam
contract allowed to do. In Salam contract, seller takes the advance full payment
from the buyer to supply some specific goods at future date. It creates a moral
obligation on the seller to deliver the goods.
The main difference between the Ishtina and Salam is that in Salam it is allowed
to take full payment, but in Ishtina the payment can be in installments.
- Ijarah – it is like a lease contract. In this contract, bank purchases any
property or equipment for an individual. In Ijarah, fixed assets must be
returned to the lessor, at the end of the lease period. If the lease agrees to
buy the asset at the end of the lessee, it is called ‘yajara wa iqtita’.
Islamic banking in all over the world
The idea of Islamic banking is not new, it has its many dimensions in all over
the world in different forms. Any financial institution that adds to the capital
of any economy is crucial. The factors that drives the growth of the market are
directing investment towards tremendous growth opportunities in the promising
According to recent research study, turnover of Islamic finance
is 1810 billion dollars: in 2020 the turnover will increase to 3,250 billion.
This huge market has attracted the interest of many countries, which are trying
to become international Islamic centers.
According to the studies, the effect of Islamic banking on finance is totally
dependent on the legal origin of the countries in which that operates. To
determine the correlation of the Islamic banks, they are negatively correlated
with the financial system developments in countries of British origin and
positively correlated to the French legal origin. Islamic banking tends to grow
Muslims prominently as Muslims are underserved financially and are from less
As of 2008, Abdus and Kabir found the implementation of Islamic banking in the
Middle East such as UAE, Kuwait, Jorden, Iran, Iraq, Turkey, Indonesia and
Malaysia. The leading areas in this regard are Malaysia and Bahrain.
Islamic Banking in Malaysia
Malaysia established the first Islamic bank in July 1983 with the incorporation
of bank Islam Malaysia buhad. After a decade, they introduced interest free
banking scheme, 17 conventional financial institutions participated and offered
Islamic financing techniques by opening ‘Islamic windows. (5) These various
techniques started developing the domestic financial system for its global
integration. In 2005, the Islamic banking industry has showed prominent results.
As a comparison with conventional banks in Malaysia, the share of Islamic
subsidiaries of commercial banks in total bank deposits has risen sharply from
3.7% in 2007 to 19.7% in 2015. (6) As mentioned earlier, the major hallmarks of
the Islamic banking are real sector connectivity and risk sharing. The current
Islamic banking products are typically same as conventional products, with shariah complaint being the differentiating factor.
The products of the Islamic subsidiaries are just Islamic as wholesome Islamic
banks. It took several centuries for Islamic bank to become what it is today; it
will take long way to go before Islamic banking can reach to a pinnacle. For
now, next few years are challenging to this industry.
Despite Malaysia, there are other countries and other parts of the world where
Islamic banking is growing to heights. In Jordan, the majority of the
populations are Muslims (92%), and as per the facts in 1980’s, Jorden was the
only Arab country in which the Islamic banking had been developing the most.
Currently, there are two major banks operating in Jorden, IIAB and JIBFI, which
has a very high growth and profitability. These banks have focused more on the
short-term investment rather than long term investment.
Even after, the global spread of Islamic banking after creation of a
trillion-dollar industry, the mainland China remains a major market where
Islamic finance has not yet reached. But this would set to change. Previously,
industrial and commercial bank of china has agreed to establish sharia complaint
banking products in China. In 2016, asset management in Hong Kong partnered with
UAE sharia complaint company to issue Islamic finance.
Islamic banks will soon be making their way into new markets where regulators
are increasingly open to accommodate this finance model. At the world economic
forum in London, David Cameron has announced the UK to become the first non-muslim
country to establish Islamic banking.
Several years, several debates and several drawn conclusions. India is a country
with 13.4% Muslims of the total population of India according to the census of
2011. The idea of introduction of the Islamic banking in India was started in
2005 by RBI. Under the directions of Ananda Sinha, RBI formed a committee where
the idea was rejected considering the existing banking system. However, Muslims
possess a greater population and the self-employment is the main source of
income for them.
Hence, to empower the community economically, there is a need
to ensure a good credit facility to them. A new committee was formed by the
planning commission under the chairmanship of Raghuram Rajan in 2008, they
suggested the interest free banking as a part of financial sector reforms.
Otherwise, the one section of the society will remain disadvantaged.
The committee gave two major recommendations: 1) interest free finance will add
to the growth and innovation in the country. 2.) After appropriate measures, the
challenges to this system can be removed.
In 2009, securities and exchange board of India gave approval for India’s first
official shariah complaint mutual find scheme, ‘Taurus ethical fund’ in 2009.
Then again, I 2010, a major step in this regard was taken by the Kerala’s
They started Islamic NBFC (Al Barakah financial services ltd.) with
a partnership of state government department. This setup greatly garners to the
growth and innovation of the Islamic banking in India. The step gave a push to
the Islamic finance in India.
However, the idea of Islamic finance received
opposition from SBI.
And inter departmental group in RBI studied the various technical and regulatory
issues for introducing interest free banking in India.
The results show that
Indian banking laws explicitly do not prohibits the Islamic banking system but
there are various provisions and there are various regulatory problems that make
this system an unrealistic option. Such banking provisions are:
- Sec 5(b) and 5(c) of the banking regulations Act, 1949 prohibits the
banks to invest in profit & loss sharing basis.
- Sec 8 of the Banking Regulations Act, prohibits the dealing in buying,
selling or bartering of goods.
- Sec 21 of the Banking Regulations Act, requires payment of interest. (7)
There are other challenges in the country too which bars it to introduce such
system as: Difficult tax procedures, Inability to maintain Capital adequacy,
confusion due to various interpretation of the Shariah by various groups.
Despite such legal and regulatory restrictions, there is need and benefit of
Sharia complaint banking as it will greatly contribute to the economic growth
and will act as a mechanism to overcome the country’s liquidity issue. If
awareness is spread among all the parts especially illiterate one’s, then that
would result in lessee exploitation. Funds for business will be available easily
to various parts. Special benefits to Muslims where the Islam support only
interest free loans. Introduction of Islamic banking in India will offer Muslims
a socio-religiously acceptable mode of finance and investment, which will
motivate many investors.
Hence, RBI recommended an ‘Islamic window in conventional banks for a gradual
introduction of Islamic banking because our Indian law needs to be changed in
order to establish Islamic banking.
Challenges of Islamic banking
What should we do?
- Tax procedures – Islamic financial products are not simple as the
products of conventional banks instead of a single contract with a onetime
government fee or stamp duty, they usually involve two or more contracts,
government fee and stamp duties, and it is also difficult to decide the tax,
whether it is income tax or sales tax. (Value added tax).
- Lack of standardization – the main challenge to Islamic banking is its
lack of regulations and standardization. Due to the various sects, there are
also various view points on the question to decide anything. For instance,
scholars of Malaysia are more flexible than those in Saudi Arabia.
- Difficult survival – Islamic financial institutions have not only
competition with each other but also with the other conventional banks and
the Islamic windows. Indian financial institutions should introduce new
ideas continuously and also should offer large number of products.
- Lack of awareness – a challenge before Islamic banking is lack of
awareness. Most people including Muslim and non-Muslim what Islamic banking
actually is, what type of product it provides and how does it work.
Therefore, there are lack of customer as well as workers and experts.
- In many countries, like India also, due to the complexities in the legal
framework, this is too difficult to implement its idea.
- First of all, there should be an advisory board at the global level to
decide, what is permissible and what is prohibited. This can be an advisory
board or any Islamic banks like world bank on WTO.
- Many countries which have Islamic banks make their separate rule and
regulation. To foster the development of Islamic finance, they should come
together and should decide about the Islamic finance collectively. There
should also be an advisory board in every country to suggest about the
- For harmonizing standards and structures, the industry does encourage
Ijtihad in the global community through international conference and
In essence, the main purpose of Islamic finance is to eliminate exploitation and
to establish a just society by the application of the sharia or Islamic ruling
in the operation of banks.
Quran states –
Deal not unjustly, and you shall not be dealt unjustly
Interest is not prohibited in Islam only, but the early Jewish and Christian
tradition also prohibit interest.
Do not charge your brother interest, whether on money or food or anything
else that may earn it interest
If you lend money to my people, to the poor among you, you are not to act as
a creditor to him. You shall not charge him interest.-
The Holy Bible
(American Standard Bible).
It is clear that many people do not take initiative to do business due to the
interest-based loan. So Islamic banking will perform the important role in these
cases because it is interest free and share of Profit and risk together.
- Islamic banking definition- Investopedia. https://www.investopedia.com/terms/islamicbanking
- Genesis of Islamic economics: a chapter in the politics of muslim
identity by Timur kumar, page 303- https:public.econ.duke.edu/tk43/abstracts/articles/ar-32A.pdf/the
- A history of Islamic finance by Naveed. https://www.islamicfinance.com/2015/02>an-overview-of-the-history-of-islamic-finance/
- Ishtina-Islamic markets, https://www.islamicmarkets.com/education/istihad.
- Islamic banking and economic growth: empirical evidence from Malaysia,
article in journal of economic coporation and develpomant : january 2009
- Islamic banking and finance in india: a koshar or a myth. October 2015.
By Aisha baduddin
Written By: Arshi Hayat Gangohi and Garima Vasuja
- LLB II year, Department
of Laws, Punjab University