Islamic Banking

Islamic Banking refers to a system of banking and financial activities that operates in accordance with Islamic law (Shariah). It prohibits practices considered unethical or exploitative under Islamic principles—most notably the payment or receipt of interest (riba). Instead, Islamic banking is based on profit-sharing, risk-sharing, asset-backing, and ethical investment, aligning financial transactions with Islamic moral and legal codes.
Over the past few decades, Islamic banking has emerged as a major component of the global financial system, serving not only Muslim-majority countries but also operating in international financial centres such as London, Singapore, and Dubai.

Historical Background

The concept of Islamic banking is rooted in Islamic economic thought, which dates back to the 7th century CE, when trade and financial dealings were governed by Qur’anic injunctions and the traditions of the Prophet Muhammad (Hadith).
However, the modern Islamic banking movement began in the mid-20th century as part of the revival of Islamic socio-economic values. Key milestones include:

• The establishment of the Mit Ghamr Savings Bank in Egypt (1963), considered the world’s first experiment in interest-free banking.
• The founding of the Islamic Development Bank (IDB) in 1975 by the Organisation of Islamic Cooperation (OIC).
• The creation of commercial Islamic banks in countries such as Dubai, Bahrain, and Malaysia during the 1970s and 1980s.

Since then, Islamic banking has grown into a trillion-dollar industry, with assets surpassing US$3 trillion globally by 2024.

Core Principles of Islamic Banking

Islamic banking operates under Shariah, which outlines specific prohibitions and ethical guidelines for financial transactions. The key principles include:

1. Prohibition of Riba (Interest):
   • Earning or paying interest is strictly forbidden.
   • Money cannot generate money on its own; income must arise from legitimate trade or investment in real assets.
2. Risk and Profit Sharing:
   • Financial transactions must involve shared risk and reward between parties.
   • Investors and entrepreneurs share profits or losses based on pre-agreed ratios.
3. Asset-Backed Financing:
   • Transactions must be backed by tangible assets such as goods, property, or services.
   • This discourages speculation and ensures finance supports the real economy.
4. Prohibition of Gharar (Uncertainty) and Maysir (Gambling):
   • Contracts with excessive uncertainty, speculation, or gambling-like elements are prohibited.
   • Financial instruments must be transparent, clearly defined, and free from deception.
5. Ethical Investment:
   • Investment in industries such as alcohol, tobacco, gambling, pornography, or arms is not allowed.
   • Funds should be directed toward socially beneficial and productive purposes.
6. Sanctity of Contracts:
   • All financial contracts must be fair, transparent, and in line with moral and social responsibility.

Major Modes of Islamic Financing

Islamic banking employs specific financial instruments designed to comply with Shariah principles. These are broadly classified into profit-sharing, trade-based, and lease-based contracts.

1. Mudarabah (Profit-Sharing):
   • A partnership between an investor (rabb-ul-mal) and an entrepreneur (mudarib).
   • The investor provides capital, and the entrepreneur manages the business.
   • Profits are shared according to a pre-agreed ratio, while losses are borne by the investor unless due to negligence.
2. Musharakah (Joint Venture):
   • Both parties contribute capital and share profits and losses proportionately.
   • Commonly used in project financing and large-scale investments.
3. Murabaha (Cost-Plus Financing):
   • The bank purchases an asset and sells it to the client at a marked-up price, payable in instalments.
   • The markup represents profit, not interest.
   • Widely used for trade and consumer financing.
4. Ijara (Leasing):
   • Similar to conventional leasing; the bank buys an asset and leases it to the client for a fixed rental period.
   • Ownership remains with the bank until the end of the contract or transfer of ownership clause.
5. Istisna (Manufacturing Contract):
   • Used for financing manufacturing or construction projects.
   • The bank finances production and delivers the finished product at a future date.
6. Salam (Forward Sale):
   • The bank pays in advance for goods to be delivered later.
   • Common in agricultural financing to support farmers before harvest.
7. Sukuk (Islamic Bonds):
   • Asset-backed certificates representing ownership in a tangible asset, project, or investment.
   • Unlike conventional bonds, sukuk holders earn returns from asset performance, not interest.

Islamic Banking vs. Conventional Banking

Global Landscape of Islamic Banking

Islamic banking has grown rapidly worldwide, particularly in Muslim-majority countries and international financial hubs.

• Major Centres: Saudi Arabia, United Arab Emirates, Malaysia, Bahrain, Qatar, Kuwait, Indonesia, and Pakistan.
• Non-Muslim Countries with Islamic Finance Presence: United Kingdom, Singapore, South Africa, and Luxembourg.
• Global Market Size: Estimated at over US$3 trillion in 2024, growing at around 10–12% annually.
• Key Institutions:
  • Islamic Development Bank (IDB)
  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
  • Islamic Financial Services Board (IFSB)
  • International Islamic Liquidity Management Corporation (IILM)

Islamic Banking in India

Although India has a large Muslim population, Islamic banking is not formally implemented within the conventional banking system due to regulatory and legal constraints, as the Banking Regulation Act (1949) does not permit interest-free operations.
However, alternative efforts have been made:

• Non-Banking Financial Companies (NBFCs) and cooperative societies operate on Shariah-compliant models in states such as Kerala and Karnataka.
• The Kerala State Government once proposed the formation of a Shariah-compliant financial institution, but it faced legal hurdles.
• Indian banks have introduced interest-free financial products in limited forms, primarily as ethical investment schemes.

The potential for Islamic finance in India remains significant, given the country’s growing financial inclusion agenda and interest in ethical finance.

Advantages of Islamic Banking

• Financial Inclusion: Provides access to banking for those excluded due to religious reasons.
• Economic Stability: Asset-backed and risk-sharing nature reduces speculative bubbles.
• Ethical Investments: Encourages socially responsible and environmentally sustainable projects.
• Wealth Equity: Promotes fair distribution of income through shared profits and losses.
• Resilience to Crises: During the 2008 global financial crisis, Islamic banks showed greater stability due to limited exposure to speculative assets.

Challenges Facing Islamic Banking

• Regulatory Barriers: Lack of standardisation and integration within conventional financial laws.
• Limited Awareness: Misconceptions about Islamic finance restrict participation.
• Liquidity Management: Fewer Shariah-compliant instruments for managing short-term funds.
• Global Integration: Variations in interpretation of Shariah across countries create inconsistencies.
• Competitiveness: Islamic products sometimes appear less flexible or less profitable than conventional ones.

Future Prospects

The future of Islamic banking looks promising, with expanding markets in the Middle East, Southeast Asia, and Africa. Growing demand for ethical and sustainable finance globally also aligns with Islamic finance principles. The integration of FinTech and digital Islamic banking platforms is expected to boost accessibility and transparency.
International cooperation through standard-setting bodies such as AAOIFI and IFSB continues to strengthen regulatory frameworks and promote harmonisation across jurisdictions.