Islamic Banking Explained

Islamic banking is defined as a banking system which is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Shariah. As per the ordainments of Shariah, Islamic banking cannot deal in transactions involving interest/riba (an increase stipulated or sought over the principal of a loan or debt). Islamic banks focus on generating returns through investment tools which are Shariah-compliant as well. The Shariah links the gain on capital with its performance. Operating within the ambit of Shariah, the operations of Islamic banking are based on sharing the risk which may arise through trading and investment activities using contracts of various Islamic modes of finance.

Major Modes of Islamic Banking
Following are the important modes of finance:

1. Participatory Modes

Mudarabah
It is a form of partnership where one party provides the funds while the other party provides expertise. The people who bring in money are called “Rab-ul-Maal” while the management and work is an exclusive responsibility of the “Mudarib”. The profit sharing ratio is determined at the time of entering into the Mudarabah agreement whereas in case of loss it is borne by the Rab-ul-Mal only. In case of Islamic banks, the depositors are called Rab-ul-Maal and the bank is called Mudarib.

Musharakah
It is a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. Under Islamic banking, it is an agreement under which the Islamic bank provides funds which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management but are not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.

2. Non-Participatory Modes

Murabaha
Murabaha is typically used to facilitate the short-term financing requirements of the customer. The mechanism of Murabaha is that the bank purchases the commodity as per requisition of the client and sells him on cost-plus-profit basis. Under this arrangement, the bank is bound to disclose cost and profit margin to the client. Therefore, the bank, rather than advancing money to a borrower, buys the goods from a third party, and sells those goods to the customer on profit.

b) Musawamah
In Musawamah, the price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well.

c) Bai Salam
It means a contract in which advance payment is made for goods to be delivered at a future date and the seller undertakes to supply some specific goods. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. Bai Salam covers almost everything which is capable of being definitely described as to quantity, quality and workmanship. For Islamic banks, this product is ideal for agriculture financing, however, this can also be used to finance the working capital needs of the customers. The permissibility of Salam is an exception to the general rule that prohibits forward sale.

d) Istisna
It is a specific kind of a Bai (sale) where the sale of the commodity is transacted before the commodity comes into existence. As far as the financing mode is concerned, it has been legalized on the basis of the principles of Istihsan (public interest).

e) Ijarah wa Iqtina (Ijarah Muntahiyyah Bittamleek)
It is allowed in Shariah that the lessor signs a separate promise (but not an agreement or contract) to gift the leased asset to the lessee at the end of the lease period, subject to his payment of all amounts of rent. There can also be a unilateral promise by the lessee to purchase the asset at the end of the Ijarah period. Alternatively, there may be an undertaking by the bank to sell the asset to the lessee at the end of the Ijarah period. However, Ijarah agreement should not be dependent either on the promise by the lessee (to purchase) or the undertaking by the bank (to sell).

3. Sub Contracts

Wakalah
Under the wakalah contract, clients give funds to the bank that serves as their investment manager. The bank charges a predetermined fee for its managerial services. The profit or loss is passed on to the fund-providers after deducting such a fee.

Kafalah
Kafalah is a contract made between the bank and another party whereby the bank agrees to discharge the liability of a third party in the case of default by the third party. As a surety, the third party will give the bank some form of collateral and pay a small fee for the services. Islamic banks use Kafalah to issue Bank and Shipping guarantees.

Rahn
Rahn, or mortgage or collateral, is defined in the Islamic jurisprudence as the possessions offered as security for a debt so that the debt will be taken from it in case the debtor failed to pay back the due money. It can also be called pawn-broking as it is an activity whereby a valuable item is collateralised to a debt which may be utilised as payment should the debt is not repaid within the agreed period. In the event the debtor is not able to repay the debt, the pawned asset will be sold off to settle the outstanding debt and any surplus will be given back to the owner of the asset.