ISLAMIC BANKING AND FINANCE

Islamic Banking and Finance

Islamic Banking and Finance

Introduction

Islamic banking is primarily an equity-based system featuring zero-based interest, share economy, equity participation, joint ventures, mutual funds, leasing, innovation and a promising rate of return. Islamic banking replaces interest-based intermediation with profit and loss sharing (PLS) and interest-free intermediation. It does not subscribe to the conventional criteria of funding on the basis of borrowers' creditworthiness and strong collateral. Therefore, bad projects with strong collateral seeking bank credit cannot substitute for good projects bearing weak collateral. In other words, Islamic banking promotes a market-based mechanism wherein available investment alternatives are appraised on their merits in terms of bringing marked improvements to the allocation and distribution of wealth and resources (Ahmed, 1994; El-Ghazali, 1994).

Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. We indicate the basic elements of the Islamic banking structure which will make it possible to include/understand the problems of our research which will be developed in the next section.

Discussion

The central feature characterizing the Islamic banking system is the absolute prohibition of the payment and receipt of interest in any transaction. Islam prohibits Muslims from taking or giving interest (riba) regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. To be sure, there have been attempts to distinguish between usury and interest and between loans for consumption and for production. It has also been argued that riba refers to usury practiced by petty moneylenders and not to interest charged by modern banks and that no riba is involved when interest is imposed on productive loans, but these arguments have not won acceptance. Apart from a few dissenting opinions, the general consensus among Muslim scholars clearly is that there is no difference between riba and interest. In what follows, these two terms are used interchangeably.

The Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production but it does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. This obviously poses the question as to what will then replace the interest rate mechanism in an Islamic framework. There have been suggestions that profit-sharing can be a viable alternative (Kahf, 1982a and b). In Islam, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit sharing permissible in Islam, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined.

As mentioned earlier, Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. To put it differently, investors in the Islamic order have no right to demand a fixed rate of ...