According to Iqbal and Llewellyn (2002), the Islamic financial system has quite a lengthy history. From the very early days, Muslims were able to establish a financial system without interest in mobilizing resources to finance productive activities and consumer needs (Marty et al, 1999). The system worked quite effectively during the heyday of Islamic civilization and for many more centuries thereafter. However, as the center of economic gravity shifted over the centuries to the Western world, Western Financial institutions became dominant and the Islamic tradition remained dormant (Karim & Archer, 2007). In the recent past, however, there has been a significant revival of interest in developing a modern version of the historic Islamic financial system in the wake of a strong desire among the Muslims to stay clear of interest, which is prohibited according to the Islamic Shariah (Karim & Archer, 2007). In countries such as Iran, Pakistan, and Sudan, there have been vigorous attempts to eliminate the role of interest in their financial systems. Other countries have allowed the establishment of Islamic banks alongside conventional banks (Iqbal & Llewellyn, 2002).
According to Ahmad (n.d.), Islam forbids charging interest on loans without caring about the motivation behind the taking of the loan. Under Islamic banking, charging interest on loans is commonly regarded as extortion. The prohibition of interest on loans is aimed at getting rid of any form of exploitation associated with the acquisition and use of loans (Karim & Archer, 2007). However, since Islamic banks customarily give loans for development purposes, the injunction of interest excludes bank loans. Unlike interest-based banking associated with conventional banks, Islamic banking is guided by the idea of a preset return on capital (Marty et al, 1999). It is, however, important to note that the prohibition against interest does not in any way hint at the fact that capital is freely available to anyone who needs it, at no cost. On the contrary, Islam does allow a return on capital, as long as the capital is used for development purposes and is subjected to normal business risks (Marty et al, 1999). A general belief held by Muslim economists is that commercial banking in any Islamic state should be organized around some type of profit-sharing that is usually represented by mudarabah and musharakah. Despite this claim, Islamic banking is not exclusively guided by mudarabah and musharakah. Many other contracts exist and are used by Islam to guide how business is generally carried out (Marty et al, 1999).
Ordinarily, Islamic banking, based on the principle of mudarabah, claims superiority over interest-based commercial banking. Among other things, it ensures a high level of efficiency, equality, steadiness, and progression. When compared to other financial systems, Islamic banking is preferred due to the allegation that the mudarabah contract is founded on the notion of promoting justice as well as equity in society. In addition, the mudarabah contract also guarantees a fairer way of allocating resources to different projects considering that the focus is usually on profitability and not the ability to return the principal amount as is the case with conventional banking (Marty et al, 1999). Ideally, projects are funded based on how profitable they are and not on the borrower’s credit rating. The Islamic practice also guards against unexpected business fluctuations especially because it is closely associated with the economy’s productive capacity. It is therefore expected that the initial cost of capital, as well as any other amount, is given to growing a business venture, will change as the business environment continues to change. In addition, it is presumed that the system has the potential to promote growth (Ahmad, n.d.).
Practices of Islamic Banks
According to Karim and Archer (2007), all Islamic banks operate current accounts on the behalf of customers. There is no major difference between conventional banks and Islamic banks when it comes to how these accounts are operated. There are, however, some distinguishing characteristics that are associated with Islamic banking. For example, current accounts under the Islamic banking practice generally govern what are known as demand deposits. These accounts may be opened by individuals or corporations in any form of currency (Karim & Archer, 2007). The interesting thing is that a customer is free to demand back his or her deposit at any time if it becomes necessary to do so. The depositor is, however, not paid any returns accruing from operating the account. Furthermore, customers give authority to the bank to make use of the deposits as it so wishes although this is at the bank’s own risk. Therefore, profits accrue to the bank and similarly, losses are born by the bank (Ahmad, n.d.).
There are also no restrictions when it comes to deposits and withdrawals and, customers have the freedom to draw checks on their current accounts. For Islamic banking institutions, there are two distinct ways of looking at the current accounts. First, the demand deposits are treated as am_nah or trust (Iqbal & Llewellyn, 2002). According to the Islamic banking institutions, this trust represents cash deposits received by the bank, and the bank is fully authorized to use these deposits at its own risk. Second, the demand deposits are treated as card Hasan or interest-free loans. Money deposited in these accounts is thus considered to be a benevolent or interest-free loan coming from the customer to the bank. Once again, the bank can freely utilize the depositors’ funds at its own risk. Card hasan requires that the bank does not need to obtain permission from the customers or depositors to use the deposited funds. The bank, therefore, benefits from any profits that accrue but bears the entire responsibility for any losses that result (Iqbal & Llewellyn, 2002).
All Islamic banks operate savings accounts. However, the way these accounts are operated differs from one bank to another. According to Ahmad (n.d.), the bank has to ask for permission to utilize the depositors’ funds. This is unlike what happens with current accounts. The customers are allowed to withdraw their cash deposits at any time as they wish and when they do so, the bank is obligated to give back all that is due to the customer. Even though all profits realized belong to the bank, the bank may choose to reward depositors by sharing with them, part of the profits generated in the course of doing business (Iqbal & Llewellyn, 2002). However, it must be understood that based on Islamic values, any return on capital is only acceptable if it is used in a way that exposes it to some form of business risk.
As is evident from the foregoing discussion, Islamic financial institutions generally carry out business operations in conformity to the laws of Islam. By so doing, these institutions are prohibited from getting involved in any financial practices that are against the values of the Islamic faith.
However, to operate smoothly in different countries, Islamic financial institutions are compelled to adhere to the existing rules and regulations that govern how business is undertaken in those countries.
Ahmad, A. (n.d). Contemporary Practices of Islamic Financing Techniques. Web.
Iqbal, M., & Llewellyn, D. T. (2002). Islamic Banking and Finance: New Perspectives on Profit Sharing and Risk. Northampton, MA: Edward Elgar Publishing.
Karim, R. A. A., & Archer, S. (2007). Islamic Finance: The Regulatory Challenge. Hoboken, NJ: John Wiley & Sons.
Marty, M. E., Appleby, R. S., Garvey, J. H., & Kuran, T. (1996). Fundamentalisms and the State: Remaking Polities, Economies, and Militance. London: University of Chicago Press.