A banking system that is based on the principles of Islamic law also known Shariah and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. Collecting interest is not permitted under Islamic law.

Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the foreign banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion.

Historical development

It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea; second, when it became a reality — by private initiative in some countries and by law in others. We will discuss the two periods separately. The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems encountered by the existing banks.

Interest-free banking as an idea

Interest-free banking seems to be of very recent origin. The earliest references to the reorganization of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961). Muhammad Hamidullah’s 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognized the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha<href=”#_ftn1″ name=”_ftnref1″ title=””>[1] – profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.

The coming into being of interest-free banks

The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House.

However, small scale limited scope interest-free banks have been tried before. The Malaysia in the mid-forties and another in Pakistan are in the late-fifties. Neither survives. In 1962 the Malaysian government set up the Pilgrim’s Management Fund to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons.However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial.

In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the UK. Many banks were established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years.

In most countries the establishment of interest-free banking had been by private initiative and was confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent profit rate depending on the type of economic activity. Interest on deposits was also converted into a guaranteed minimum profit. In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.

Current practices

Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank’s circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient features common to all banks.

Deposit accounts

All the Islamic banks have three kinds of deposit accounts: current, savings and investment.

Current accounts

Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed.

Savings accounts

Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.

Investment account

Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.

Modes of financing

Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorized into three areas: investment, trade and lending.

Investment financing

This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profit and loss are shared in a pre-arranged fashion. This is not very different from the joint venture concept. The venture is an independent legal entity and the bank may withdraw gradually after an initial period. b) Mudarabha where the bank contributes the finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank. c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. (Perhaps this rate is negotiable.) If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will take a share in it.

Trade financing

This is also done in several ways. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis.


Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge.


Other banking services such as money transfers, bill collections, trade in foreign currencies at spot rate etc. where the bank’s own money is not involved are provided on a commission or charges basis.

Shortcomings in current practices

In the previous section we listed the current practices under three categories: deposits, modes of financing (or acquiring assets) and services. There seems to be no problems as far as banking services are concerned. Islamic banks are able to provide nearly all the services that are available in the conventional banks. The only exception seems to be in the case of letters of credit where there is a possibility for interest involvement. However some solutions have been found for this problem — mainly by having excess liquidity with the foreign bank. On the deposit side, judging by the volume of deposits both in the countries where both systems are available and in countries where law prohibits any dealing in interest, the non-payment of interest on deposit accounts seems to be no serious problem. Customers still seem to deposit their money with interest-free banks.

The main problems, both for the banks and for the customers, seem to be in the area of financing. Bank lending is still practiced but that is limited to either no-cost loans (mainly consumer loans) including overdrafts, or loans with service charges only. Both these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks’ main income is to come from and this is also from where the investment account holders are expected to derive their profits from. And the latter is supposed to be the incentive for people to deposit their money with the Islamic banks. And it is precisely in this PLS scheme that the main problems of the Islamic banks lie. Therefore we will look at this system more carefully in the following section.

Long-term projects

Table 1 shows the term structure of investment by 20 Islamic Banks in 1988. It is clear that less than 10 percent of the total assets goes into medium- and long-term investment. Admittedly, the banks are unable or unwilling to participate in long-term projects. This is a very unsatisfactory situation.

Table 1

Term Structure of Investment by 20 Islamic Banks, 1988
Type of Investment Amount* % of Total
Short-term 4,909.8 68.4
Social lending 64.2 0.9
Real-estate investment 1,498.2 20.9
Medium- and long-term investment 707.7 9.8

Source: Aggregate balance sheets prepared by the International Association of Islamic Banks, Bahrain, 1988. Quoted in: Ausaf Ahmed (1994). * Unit of currency not given.

The main reason of course is the need to participate in the enterprise on a PLS basis which involves time consuming complicated assessment procedures and negotiations, requiring expertise and experience. The banks do not seem to have developed the latter and they seem to be averse to the former. There are no commonly accepted criteria for project evaluation based on PLS partnerships. Each single case has to be treated separately with utmost care and each has to be assessed and negotiated on its own merits. Other obvious reasons are: a) such investments tie up capital for very long periods, unlike in conventional banking where the capital is recovered in regular installments almost right from the beginning, and the uncertainty and risk are that much higher, b) the longer the maturity of the project the longer it takes to realize the returns and the banks therefore cannot pay a return to their depositors as quick as the conventional banks can. Thus it is no wonder that the banks are averse to such investments.


Existing banking laws do not permit banks to engage directly in business enterprises using depositors’ funds. But this is the basic asset acquiring method of Islamic banks. Therefore new legislation and/or government authorization are necessary to establish such banks. In Iran a comprehensive legislation was passed to establish Islamic banks. In Pakistan the Central Bank was authorized to take the necessary steps. In other countries either the banks found ways of using existing regulations or were given special accommodation. In all cases government intervention or active support was necessary to establish Islamic banks working under the PLS scheme.

In spite of this, there is still need for further auxiliary legislation in order to fully realize the goals of Islamic banking. For example, in Pakistan, the new law has been introduced without fundamental changes in the existing laws governing contracts, mortgages, and pledges. Similarly no law has been introduced to define modes of participatory financing; that is Musharakah and PTC s. It is presumed that whenever there is a conflict between the Islamic banking framework and the existing law, the latter will prevail. In essence, therefore, the relationship between the bank and the client, that of creditor and debtor is left unchanged as specified by the existing law.

The existing banking law was developed to protect mainly the credit transactions; its application to other modes of financing results in the treatment of those modes as credit transactions also. Banks doubt whether some contracts, though consistent with the Islamic banking framework, would be acceptable in the courts. Hence, incentives exist for default and abuse.

In Iran, although the law establishing interest-free banking is comprehensive, the lack of proper definitions of property rights may have constrained bank lending. Thus far there has been no precise legislative and legal expression of what is viewed as lawful and conditional private property rights. This may also have militated against investment lending in agricultural and industrial sectors and thus encouraged increased concentration of assets in short-term trade financing instruments.

Islamic banking in non-Muslim countries

The modern commercial banking system in nearly all countries of the world is mainly evolved from and modeled on the practices in Europe, especially that in the United Kingdom. The philosophical roots of this system revolve around the basic principles of capital certainty for depositors and certainty as to the rate of return on deposits. In order to enforce these principles for the sake of the depositors and to ensure the smooth functioning of the banking system Central Banks have been vested with powers of supervision and control. All banks have to submit to the Central Bank rules. Islamic banks which wish to operate in non-Muslim countries have some difficulties in complying with these rules.

Supervision and control

Besides these, there are other concerns as well. One is the Central Bank supervision and control. This mainly relates to liquidity requirements and adequacy of capital. These in turn depend on an assessment of the value of assets of the Islamic banks. A financial advisor has this to say:

The bank of England, under the 1979 Act, would have great difficulty in putting a value on the assets of an Islamic institution which wanted to operate as a bank in the UK. The traditional banking system has much of its assets in fixed interest instruments and it is comparatively easy to value that. For example, if they are British Government instruments they will have a quoted market value; and there are recognized methods for valuing traditional banking assets when they become non-productive. But it is very difficult indeed to value an Islamic asset such as a share in a joint venture; and the Bank of England would have to send a team of experienced accountants into every Islamic bank operating in the UK as a bank under the 1979 Act, to try to put a proper and cautious value on its assets.

Another financial analyst states:

Even if a method could be found for assessing the risks to calculate the capital necessary, little comfort could be taken from the profitability which is usually relied upon to cover day-to-day losses arising from the banks business, because a substantial part of an Islamic banks portfolio is venture capital without any guaranteed return.

It is evident then that even if there is a desire to accommodate the Islamic system, the new procedures that need be developed and the modifications that need be made to existing procedures are so large that the chances of such accommodation in a cautious sector such as banking is very remote indeed. Any relaxation of strict supervision is precluded because should an Islamic bank fail it would undermine the confidence in the whole financial system, with which it is inevitably identified. As Suratgar puts it:

There could be potential dangers for the international system, where the failure of such an institution could bring with it the failure of other associated institutions, or of all the Western banking institutions which come closely tied to with such an operation.

The question has engaged the attention of Central Banks in Muslim countries as well. But reliable satisfactory methods are still too developed.


Islamic banking is a very young concept. Yet it has already been implemented as the only system in two Muslim countries; there are Islamic banks in many Muslim countries and a few in non-Muslim countries as well. Despite the successful acceptance there are problems. These problems are mainly in the area of financing.

With only minor changes in their practices, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. All the necessary ingredients are already there. The modified system will make use of only two forms of financing — loans with a service charge and Mudaraba participatory financing — both of which are fully accepted by all Muslim writers on the subject.

Such a system will offer an effective banking system where Islamic banking is obligatory and a powerful alternative to conventional banking where both co-exist. Additionally, such a system will have no problem in obtaining authorization to operate in non-Muslim countries.

Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.


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<href=”#_ftnref1″ name=”_ftn1″ title=””>[1] The mudaraba is a variant of the musharaka. Essentially, it is a profit and loss sharing partnership in which there is a clear distinction in the nature of the parties and their respective contributions.

<href=”#_ftnref2″ name=”_ftn2″ title=””>[2] Al – Musharakah (2006), available at: http://sharia-banking.blogspot.com/2006/10/al-musharakah.html (accessed July).