Islamic banking or Islamic finance (Arabic: مصرفية إسلامية‎) or sharia-compliant finance[1] is banking or financing activity that complies with sharia (Islamic law) and its practical application through the development of Islamic economics. Some of the modes of Islamic banking/finance include Mudarabah (profit-sharing and loss-bearing), Wadiah (safekeeping), Musharaka (joint venture), Murabahah (cost-plus), and Ijara (leasing).

The Qur’an prohibits riba, which literally means “increase”. Technically riba is the increase when liquid or fungible assets (cash, debt, grains, etc.) are exchanged other than at par value. The most prevalent example in today’s economy is lending money at interest, for example an exchange of $100 cash now for $110 payable in a year’s time, an increase of $10. (Some Muslims dispute whether there is a consensus that interest is equivalent to riba).[2][3] Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haraam (“restricted, or excluded”).

These prohibitions have been applied historically in varying degrees in Muslim countries/communities to prevent un-Islamic practices. In the late 20th century, as part of the revival of Islamic identity,[4][Note 1] a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community.[6][7] Their number and size has grown, so that by 2009, there were over 300 banks and 250 mutual funds around the world complying with Islamic principles,[8] and around $2 trillion was sharia-compliant by 2014.[9] Sharia-compliant financial institutions represented approximately 1% of total world assets,[10] concentrated in the Gulf Cooperation Council (GCC) countries, Iran, and Malaysia.[11] Although Islamic banking still makes up only a fraction of the banking assets of Muslims,[12] since its inception it has been growing faster than banking assets as a whole, and is projected to continue to do so.[9]

The industry has been lauded for returning to the path of “divine guidance” in rejecting the “political and economic dominance” of the West,[4] and noted as the “most visible mark” of Islamic revivalism,[13] its most enthusiastic advocates promise “no inflation, no unemployment, no exploitation and no poverty” once it is fully implemented.[14][15] However, it has also been criticized for failing to develop profit and loss sharing or more ethical modes of investment promised by early promoters,[16] and instead selling banking products[17] that “comply with the formal requirements of Islamic law”,[18] but use “ruses and subterfuges to conceal interest”,[19] and entail “higher costs, bigger risks”[20] than conventional (ribawi) banks.

Philosophical foundation

The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behaviour. The Islamic financial
system can be fully appreciated only in the context of Islam’s teachings on the business ethic, wealth distribution, social and economic justice, which are at the centre of a moral economy. Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions with their material outcomes, the Islamic system places equal emphasis on the ethical, moral, social, and public interest dimensions, to enhance equality and fairness as well as the role of the state. The principles underlying the Shari’ah (referred to as Islamic law) and its practical application through the development of Islamic economics. Practitioners and clients need not be Muslims, but they must accept the ethical and moral prohibitions underscored by values emphasised in Islamic teachings founded on the Qur’an, the Hadith (the sayings and conduct of Prophet Muhammad (pbuh) and interpretation by Islamic scholars.

 What is Islamic finance?

Based on the article on Islamic Financial System by Zamir Iqbal, World Bank publication

Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. The objectives (maqsid) of Islamic finance transactions may be summarised as below:

  • To be true to the Shari’ah principles of equity and justice;
  • Should be free from unjust enrichment;
  • Must be based on true consent of all parties;
  • Must be an integral part of a real trade or economic activity such as a sale, lease, manufacture or partnership.