As the name suggests, Islamic banking is based on Sharia (Islamic law). The main objective of this financial system is to encourage economic activities and provide basic financial services to the community. It focuses more on encouraging savings rather than interest income from loans. The term ‘Islamic banking’ was coined to explain a variety of different types of banking systems whose principles are derived from Islamic principles and laws. Unlike conventional banking which takes interest as its major source, Islamic banks do not accept or lend capital for the purpose of making profits. In an article published in the Harvard Business Review by Michael Gessel, John Kehoe and Alaa El-din Abou-Elkheir it explains that Islamic finance has become a mainstream financial system preferred by global investors for its proven risk management practices and cost efficiency. The article also states that there are at least 200 institutions around the world operating with an aim of implementing Islamic finance principles into their operations as well as those of their customers.
What Is Islamic Banking?
Islamic banking is a term used to describe different types of financial services which are based on the principles of Sharia, or Islamic law. The principles of Sharia are quite clear about where a transaction should occur. These principles of Islamic banking are not just for banking but also for all economic activities.
- The Shariah prohibits earning riba from money because this is considered as a form of cheating.
- The Islamic banking is a complete system that is not just about money lending but also about insurance, investment, investment portfolio management, retirement funds, and other services.
Objectives of Islamic Banking:
Islamic banking is both a business and an ideology. Upon successfully completing the Islamic banking and finance courses and working with Islamic financial institutions, the practitioners try to incorporate the objectives of Islamic finance in the business operations of their institutions. These objectives are:
Providing Opportunities for Saver and Investor:
The Islamic finance is a system in which interest is not allowed. The aim is to provide the opportunity for the savers who do not want to pay any interest on their savings to earn a profit by investing the money. The profits are paid by the people who take a loan on interest. So, the objective of Islamic banking is to create a system that encourages the savers to invest their money and also to create a business system.
Reducing Risk:
Islamic banking has clear rules in every transaction and contract to prevent fraud or cheating. Hence, there is no scope for any risk or fraud. The Islamic banking is a very safe system.
Maintaining the Value and Supply of Assets:
Islamic finance has a proper set of rules to maintain the value of assets and guarantee their supply to the customers. This system is more responsible and reliable for the customers.
Types of Islamic Banking System
There are many different types of Islamic banking and financing. These include:
Investment Banking:
This type of Islamic banking focuses on providing asset management services. Investment banks offer wealth management, investment brokerage, and asset/equity trading, such as ijarah to their customers. The investment banks provide services such as investment advice, financial planning, investment research, investment banking, and investment management.
Debt Securities, Notes, and Bonds:
These are financial instruments that provide a promise to pay the customer a certain amount of money at a specified time.
Equity:
This is a type of financial instrument in which the investor owns shares in an entity such as a company or an investment fund.
Risks in Islamic Banking
As the name suggests, Islamic banking is based on Sharia. So, it is completely prohibited to earn interest or any form of profit from these financial transactions. However, it is not feasible to prohibit earning interest from business transactions. So, the Islamic banks have taken a compromise and allowed ‘interest-free payment system’ from the customers. These are known as Ijara contracts. Islamic banks are required to invest the money that comes from the customers into the government bonds (ijara). So, the customers have no risk as there is a certain amount of interest that the bank has to pay. But, there are some disadvantages too of non-Islamic bank in this contract. The customers have to pay a certain amount of interest for the security that the bank will give.
Advantages of Islamic Banking
- All the benefits of conventional banking without any risk of loaning and taking high interest on the loan.
- As per the statistics, the profit of the Islamic banks is more than 8 times higher than the benefit of a conventional bank. This is because the cost of operating an Islamic bank is less than the conventional bank.
- You can withdraw or deposit any amount of money at any time without any scrutiny or authorization.
- You can also save loan without any fear of defaulting. – You can borrow money without pledging any security.
- There are no restrictions on the countries where Islamic banking can be practiced.
Conclusion
Islamic finance is growing at an unprecedented rate. According to a report by the International Islamic Financial Institutions (IIF), the total assets under Islamic finance industry are estimated to be close to $4.6 trillion in 2024. This growth can be attributed to the increasing interest among investors in the principles of Shariah. Moreover, the growth of the internet has also helped in making things easier and simpler for the investors to invest in the Islamic finance.