Practiced in Muslim countries, Islamic banking refers to the system of banking that is in accordance with the Sharia (Islamic law). The absence of an interest mechanism forms the core of Islamic banking.
The basic foundations of the Islamic banking system are the concepts of usury and risk. Islamic law does not consider money as an asset. Hence, lending money on interest is prohibited. According to Islam, the lending of money is considered as an unjust act as it is seen as favoring the lender. According to Islamic finance, money is just a measuring tool for value. Therefore, ‘riba’ or usury or interest is prohibited.
In the Sharia banking system, when an enterprise takes a loan, it shares part of its profits with the lending agency. Also, the sale and purchase of such items is prohibited the existence of which is considered uncertain. Thus, mainstream financialinstruments, such as derivatives which are used to hedge possible outcomes, are prohibited in the Islamic system of banking and finance.
Islamic Banking: How it Works
The core concept of Islamic banking, the sharing of profit and loss contracts, is known as the ‘mudarabeh.’ In Islamic banking practices, investors’ money is pooled by the bank and a share of profit and loss is assumed. The bank invests this pooled fundin a group of mutual funds that are screened for compliance with the Sharia. Also, it is determined whether the company in which the money is invested by the bank passes the filter of Islamic principles. This essentially means that the company should not be involved in prohibited activity, such as engaging in holding too much debt or producing prohibited items such as alcohol.
The surge of oil wealth in the Muslim countries in the 1970s gave an impetus to the Islamic banking industry. A number of financial products have been devised that are claimed to be adhering to the Islamic financial principles. Apart from the actively managed mutual funds, where the Islamic banks invest, passively managed mutual funds also exist. These are based on specific indices such as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.