Islamic Banking

Introduction

A central tenet of an economic system based on Islamic principles is the absolute prohibition on the payment and receipt of interest. It is this prohibition that makes Islamic banks and financial institutions differ in a fundamental sense from their Western counterparts. As the use of the interest rate in financial transactions is precluded, Islamic banks are expected to conduct operations only on the basis of profit-sharing arrangements or other modes of financing permissible under Islamic law (Fuller and Jonas 94).

At present about 45 countries, encompasing most of the Muslim world, have some type of Islamic banking or financial institutions. This development, which has gained momentum since the second half of the 1970s, has basically taken two forms. The first has been an attempt to establish Islamic financial institutions side by side with traditional banking. In such attempts, two types of institutions have evolved (Boyer 24).

Islamic banks, established mostly in Muslim countries, and Islamic investment and holding companies, operating in some Muslim but mostly in non-Muslim countries. In both cases, generally, the banking operations of Islamic banks are subject to specific regulations that apply to all banks. Examples of Islamic banks are the Faisal Islamic Banks in Egypt and the Sudan, the Dubai Islamic Bank, and the Jordan Islamic Bank. Examples of investment companies having either a national or an international mandate include the Darul Mal AI-Islami (Geneva), the Islamic Investment Company (Bahamas), and the Bahrain Islamic Investment Bank. These institutions compete with conventional banks to attract deposits-but without paying a predetermined interest rate-and invest these funds wherever they find profitable investment opportunities. The majority of these institutions were established through private initiatives.

History & Development

It is difficult to pinpoint the start of Islamic banking, but the consensus is that it took place in Egypt in the 1960s. The Egyptian experiment did not last very long, and it was not until the mid 1970s before Islamic banking started to take hold in many Muslim countries. The change can partly be explained by two main factors. First, the 1970s saw two oilprice shocks, which led to a massive transfer of wealth from the oil-consuming to the oil-producing countries. The accompanying increase in per capita income led many to seek an alternative to traditional banking that was consistent with Islamic teaching. Second, the second oil shock coincided with the Iranian revolution, which brought about the Khomeini government and the first Islamic republic (Boyer 105). Thus began an Islamic revival that spread to other countries and paved the way for more financial institutions of the Islamic type.

Principles of Islamic Banking & Modern Banking System

The principal restriction under which the Islamic financial system must work is the injunction against interest. However, it is important to note that what is forbidden by Islamic law is the fixed or predetermined return on financial transactions, and not an uncertain rate of return represented by profits (Omar and Abdel 24). For this reason the modern concept of Islamic banking has developed on the basis of profit ...