What is Islamic Banking?

What is Islamic Banking?

Islamic banking is the provision of banking services with an end-to-end Shariah-friendly setup. There are two notable differences between an Islamic bank (IB) and a conventional bank; firstly, IBs do not involve interest in their operations at all whilst interest is at the heart of a conventional bank. Secondly, conventional banks lend money as the primary method of financing and also create money to lend to customers. On the other hand, IBs do not lend funds, they invest or purchase.

The payment of interest on loans is fundamentally prohibited in Islam. It represents an unjust payment which a borrower should never be subjected to. Likewise, a lender has no right to a fee for a charitable action such as lending. Regardless of the amounts involved, it is a matter of principle. Further, such interest payments mushroom into a macro culture which has the potential to have an adverse and detrimental impact on the economy.

In addition to the regulatory guidelines and legal frameworks a bank adheres to, an IB is further governed and regulated by an Islamic framework which adds to its transparency, good corporate governance, social corporate responsibility, accountability, ethical HR practices and enhanced consumer protection. This additional Islamic framework is manifest in all the different departments and practices of an IB. Thus, the assets’ side, liabilities side, accounts management, liquidity management, treasury management, underlying contracts, marketing and communications, human resources and governance are all enhanced with Shariah principles and guidance. The key areas and distinctions of an IB are as follows: 

1. Assets’ side

An assets’ side of an IB does not lend on interest. Customers looking for financing will not receive a loan; rather, Islamic financing will be asset-backed and the IB will invest and trade as opposed to merely lend. IBs use Shariah compliant products such as Diminishing Musharakah, Wakalah, Ijarah, Commodity Murabahah, Salam and Istisna’ to provide financing to customers.

2. Liabilities’ side

The liabilities’ side of an IB does not pay interest to depositors. An IB usually accepts deposits under a Wakalah (agency) agreement. Thereafter, the IB invests these funds and pays out profit to the account holders. The relationship between a customer and an IB is not that of a borrower and lender, rather it is of principal and agent. Furthermore, the underlying contracts, terms and conditions are all in conformity with Shariah principles ensuring that neither counterparty is disadvantaged, unfairly enriched or unjustly treated.

Liquidity management

Liquidity risk is one of the several risks to which banks, including IBs, are exposed to. It results from the mismatch between maturities of assets and liabilities. The different maturity structure of assets (mainly medium and long-term) and liabilities (mostly short-term) generates the risk that the bank is unable to respond immediately to requests for payment or forces the bank to quickly sell a high volume of financial assets in its portfolio accepting the price much lower than the market value. 

IB manage their liquidity risk with Shariah compliant liquidity management tool, this includes commodity murabaha, interbank placement of funds under various profit sharing arrangements and Islamic mutual funds.   

Treasury management

Although the term treasury management and liquidity management are used interchangeably by financial institutions, yet, they are not the same. Treasury management deals with the foreign currency and exchange risk, while liquidity management involves managing the liquidity position of the company. Unlike conventional banks and their treasury management, IBs use a number of Shariah compliant products for treasury management such as Sukuk, Murabahah and Wakalah products.

Contractual agreements

The underlying contracts and agreements of IBs are all reviewed by Shariah advisors to ensure that they meet Shariah principles. This ensures that agreements are fair, just and equitable. The Shariah screening of agreements remove uncertain elements, contractual enrichment and any clause which can create unwarranted dispute.

Marketing and communication

Another visible mark of an IB is the Islamic messaging and marketing. All marketing materials are designed to meet Shariah requirements and espouse Islamic culture and tradition. The artwork resonates with Islamic architecture and there is often a spiritual message in the marketing.

Culture and Environment

One key feature of IBs is that it breeds an Islamic culture internally, with customers and partners. This is experienced on the way one is greeted, the language used in conversations, the seasonal celebrations, activities and overall messaging within branches.

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