Finance

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What is Islamic Banking?

Christopher John

Last Modified Date: February 08, 2024

Islamic banking applies the laws, values and beliefs of the Islamic faith to its method of operations. The term Sharia means laws, values and religion. The term mu'amalat refers to the rules of Sharia that apply specifically to contracts and transactions. In essence, the Sharia provides the moral values for Islamic banking. It is like a code of ethics.

The Sharia is the key to understanding Islamic banking. The Sharia derives its rules from three sources, which are the Quran, the Sunnah, and Islamic religious scholars. The Quran contains the revelations of Allah or God. According to Muslims, Allah made these revelations to the prophet Muhammad. The Quran is the source of Islamic law.

Islamic banking is based on Sharia, the law derived mainly from the Quran.

The Sunnah refers to the teachings of Muhammad. It also includes the way Muhammad lived his life, which serves as an example for followers of Islam. The Sunnah is contained in the Hadith, which are books. To understand the Quran, a person must also study the Sunnah.

Islamic religious scholars provide interpretation, guidance, and advice for institutions engaged in Islamic banking. If the Quran and the Sunnah do not address a particular situation, then Islamic religious scholars will provide guidance for Islamic banks. Islamic religious scholars have developed Sharia supervisory boards or advisory boards to fill the needs of Islamic banking. These boards help Islamic banks by ensuring compliance with the Sharia. The Sharia boards are independent of the banks and function like a regulatory agency.

In Islam, the term "mu'amalat" refers to religious laws that apply to financial transactions and contracts.

Interpretations provided by the Sharia boards must be consistent with the Quran and Sunnah. Islamic banks must comply with the religious rulings of the Sharia boards. The term fatwa refers to a ruling of the Sharia board. If a financial institution does not comply with the Sharia, then it is not engaged in Islamic banking.

A key rule of Sharia applicable to Islamic banking is to avoid the assessment of interest. The Quran teaches that Allah has forbidden riba. Riba means interest or usury. Accordingly, Islamic banking cannot charge interest on its loans. Furthermore, Islamic banking cannot pay interest to its customers for depositing money into savings accounts with the bank because the Sharia forbids both assessment and payment of interest.

Islamic banks provide services comparable to the services provided by western banks. Examples of services include checking accounts, electronic fund transfers, travelers’ checks, safe deposit boxes, and letters of credit. The bank charges its customers a fee for the various services instead of interest. An Islamic bank must obtain prior approval from the Sharia board before offering any new products or services. After obtaining approval, the bank may introduce the new products and services to its customers.

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Discussion Comments

anon926710

January 20, 2014

Muslims who own accounts in western banks do so because they need to keep their money somewhere. Those who follow the shariah principles do not use the interest paid on their accounts. That interest is usually taken and donated to charities on the basis of not benefiting the banks and making the money work constructively for other more deserving charitable causes.

Muslims who have large amounts of cash do not leave it in banks or building societies. They invest it in profit and loss ventures. This is a good and ethical thing as this means money is working in the community instead of simply sitting in the banks riding on other people's toils.

serenesurface

March 31, 2011

@burcinc-- There are some Islamic banks in USA, my family uses one.

It's okay for Muslims to use an American bank if they only have a checking account. My brother wanted to work in an American bank but my father did not approve of it. Some Muslims think that working in a bank that charges and gives interest is sinful also, because you are helping and participating in that activity.

burcidi

March 28, 2011

@burcinc-- I think it depends on the country. If the government is Islamic, then it might just have Islamic banks. But if it's a democratic government, then I'm sure they would have Western type banks also. Can someone who is more informed on this help us out here?

I have a Muslim friend and she uses the same bank that I do. She just doesn't have a savings account because of the interest. I think it's fine for Muslims to use Western banks that way.

burcinc

March 27, 2011

Are banks with the Western system not allowed in Muslim countries, then?

I have never seen a Muslim bank in the U.S. What do Muslims who live in non-Muslim countries do for their banking needs?

And what happens if they use regular Western banks, are they criticized by the Islamic community if they use Western banks? I think it would be hard to follow Islamic principles in banking if you don't live in an Islamic country.

discographer

March 25, 2011

Yes, Islamic banks must comply with Sharia but this doesn't mean that all Islamic banks in different nations work exactly the same.

I've used banks in several different Muslim countries and noticed that the checking accounts did not work the same in all of them. I think that the reason behind this is that a lot of Islamic laws and principles are open to interpretation and different religious authorities tend to interpret in different ways.

So, yes every Islamic bank is working according to Sharia, but Sharia that is interpreted by that country. I guess if there was an economic union among Arab or Muslim nations in the future, and if they could agree on one interpretation, then all the banks could work exactly the same way.