Islamic Banking

Banking products including Islamic Finance Other sources of funding
Many of the products offered by Islamic financial institutions are comparable to Western or
conventional finance even though interest and speculation are forbidden. Banks are by far the biggest
players in Islamic finance—some of them are exclusively Islamic while others offer Sharia-compliant
products but remain mostly conventional.
Aside from the absence of interest rates, the key concept of Islamic finance is risk sharing between
parties in all operations. Here are some of the key sharia-compliant products offered by banks—they
have Arabic names but in most cases, we can find an equivalent in conventional Western banking.
Murabaha or cost plus selling: This is the most common product in asset portfolios and applies only to
commodity purchases. Instead of taking out an interest loan to buy something, the customer asks the
bank to purchase an item and sell it to him or her at a higher price on installment. The bank’s profit is
determined beforehand and the selling price cannot be increased once the contract is signed. In case of
late or default payment, different options are available including a third-party guarantee, collateral
guarantees on the client’s belongings or a penalty fee to be paid to an Islamic charity since it can’t enter
the bank’s revenues.
Ijara or leasing: Instead of issuing a loan for a customer to buy a product like car, the bank buys the
product and then leases it to the customer. The customer acquires the item at the end of the lease
contract.
Mudarabah or profit share: An investment in which the bank provides 100% of the capital intended for
the creation of a business. The bank owns the commercial entity and the customer provides
management and labor. They then share the profits according to a pre-established ratio that is usually
close to 50/50. If the business fails, the bank bears all the financial losses unless it is proven that it was
the customer’s fault.
Musharakah or joint venture: An investment involving two or more partners in which each partner
brings in capital and management in exchange for a proportional share of the profits.
In some cases, the fund manager creates a waqf, or a charity fund.
Sukuk or bonds: Sharia-compliant bonds began to be issued in the 2000s and standardized by the AAOIF
—a Bahrain-based institution that promotes sharia-compliant regulation since 2003. Today, over 20
countries use this instrument. Malaysia is the biggest issuer, followed by Saudi Arabia and issuers
outside the Muslim world include the UK, Hong Kong, and Luxembourg.
Islamic Finance
What is Islamic Finance?
Islamic finance is a type of financing activity that must comply with Sharia
(Islamic Law). The concept can also refer to the investments that are
permissible under Sharia.
The common practices of Islamic finance and banking came into existence
along with the foundation of Islam. However, the establishment of formal
Islamic finance occurred only in the 20th century. Nowadays, the Islamic finance
sector grows at 15%-25% per year, while Islamic financial institutions oversee
over $2 trillion.
The main difference between conventional finance and Islamic finance is that
some of the practices and principles that are used in conventional finance are
strictly prohibited under Sharia laws.
Principles of Islamic Finance
Islamic finance strictly complies with Sharia law. Contemporary Islamic finance
is based on a number of prohibitions that are not always illegal in the
countries where Islamic financial institutions are operating:
1. Paying or charging an interest
Islam considers lending with interest payments as an exploitative practice that

favors the lender at the expense of the borrower. According to Sharia law,
interest is usury (riba), which is strictly prohibited.
2. Investing in businesses involved in prohibited activities
Some activities, such as producing and selling alcohol or pork, are prohibited
in Islam. The activities are considered haram or forbidden. Therefore, investing
in such activities is likewise forbidden.
3. Speculation (maisir)
Sharia strictly prohibits any form of speculation or gambling, which is

called maisir. Thus, Islamic financial institutions cannot be involved in
contracts where the ownership of goods depends on an uncertain event in the
future.
4. Uncertainty and risk (gharar)
The rules of Islamic finance ban participation in contracts with excessive risk
and/or uncertainty. The term gharar measures the legitimacy of risk or
uncertainty in investments. Gharar is observed with derivative contracts and
short-selling, which are forbidden in Islamic finance.
In addition to the above prohibitions, Islamic finance is based on two other

crucial principles:
 Material finality of the transaction: Each transaction must be related

to a real underlying economic transaction.
 Profit/loss sharing: Parties entering into the contracts in Islamic finance
share profit/loss and risks associated with the transaction. No one can
benefit from the transaction more than the other party.
 g: Parties entering into the contracts in Islamic finance share profit/loss
and risks associated with the transaction. No one can benefit from the
transaction more than the other party.
Types of Financing Arrangements
Since Islamic finance is based on several restrictions and principles that do not
exist in conventional banking, special types of financing arrangements were
developed to comply with the following principles:
1. Profit-and-loss sharing partnership (mudarabah)
Mudarabah is a profit-and-loss sharing partnership agreement where one

partner (financier or rab-ul mal) provides the capital to another partner (labor
provider or mudarib) who is responsible for the management and investment
of the capital. The profits are shared between the parties according to a pre-
agreed ratio.
2. Profit-and-loss sharing joint venture (musharakah)
Musharakah is a form of a joint venture where all partners contribute capital

and share the profit and loss on a pro-rata basis. The major types of these
joint ventures are:
 Diminishing partnership: This type of venture is commonly used to

acquire properties. The bank and investor jointly purchase a property.
Subsequently, the bank gradually transfers its portion of equity in the
property to the investor in exchange for payments.
 Permanent musharkah: This type of joint venture does not have a
specific end date and continues operating as long as the participating
parties agree to continue operations. Generally, it is used to finance
long-term projects.
3. Leasing (Ijarah)
In this type of financing arrangement, the lessor (who must own the property)
leases the property to the lessee in exchange for a stream of rental and
purchase payments, ending with the transfer of property ownership to the
lessee.
Investment Vehicles
Due to the number of prohibitions set by Sharia, many conventional

investment vehicles such as bonds, options, and derivatives are forbidden in
Islamic finance. The two major investment vehicles in Islamic finance are:
1. Equities
Sharia allows investment in company shares. However, the companies must

not be involved in activities prohibited by Islamic laws, such as lending at
interest, gambling, production of alcohol or pork. Islamic finance also allows
private equity investments.
2. Fixed-income instruments
Since lending with interest payments is forbidden by Sharia, there are no

conventional bonds in Islamic finance. However, there is an equivalent of
bonds called sukuk or “Sharia-compliant bonds.” The bonds represent partial
ownership in an asset, not a debt obligation.

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Banking products including Islamic Finance Other sources of funding

In some cases, the fund manager creates a waqf, or a charity fund.

Principles of Islamic Finance

1. Paying or charging an interest

Islam considers lending with interest payments as an exploitative practice that

2. Investing in businesses involved in prohibited activities

Sharia strictly prohibits any form of speculation or gambling, which is

4. Uncertainty and risk (gharar)

In addition to the above prohibitions, Islamic finance is based on two other

 Material finality of the transaction: Each transaction must be related

1. Profit-and-loss sharing partnership (mudarabah)

Mudarabah is a profit-and-loss sharing partnership agreement where one

2. Profit-and-loss sharing joint venture (musharakah)

Musharakah is a form of a joint venture where all partners contribute capital

 Diminishing partnership: This type of venture is commonly used to

Due to the number of prohibitions set by Sharia, many conventional

Sharia allows investment in company shares. However, the companies must

Since lending with interest payments is forbidden by Sharia, there are no

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