Understanding Islamic Banking
What is an Islamic Bank?
How did the methods of Islamic financing save Islamic banks from the global crisis?
An Islamic bank is a bank that complies with the principles of Shari'a in all financing, banking and investment transactions and is subject, as a financial institution, to the supervision and control of the Central Bank. In addition, an Islamic bank complies with Shari'a principles in all the transactions and products it provides to its clients, whether such products are investment deposits, investment certificates or savings accounts. An Islamic bank also meets the client's various financing needs by providing many options such as: Murabaha (Cost-plus), Musharakah (Joint Venture), Ijarah (Leasing); as well as offers Islamic options for letter of guarantee, letter of credit and covered cards. The Islamic bank has a Shari'a Board composed of Islamic jurists who are continually consulted regarding all aspects of new banking transactions.
Although the global crisis has affected banks worldwide, Islamic banks have not been affected by the crisis.
The mortgage crisis, which initially emerged in the USA, was the first and key cause of the crisis. Among the other causes of the global recession included debt factoring in the USA, Europe and Asia-major banks offered loans that exceeded the value of deposits-as well as margin selling, known as derivatives.
The stability of Islamic banks stems from the nature of their businesses, since their financing methods are based on Islamic Shari'a dictates such as Murabaha, Musharakah, Mudarabah and Ijarah.
History of Islamic Banking
Islamic banking practices began in the 70's in Egypt, KSA and UAE.
By 2003, Islamic banks became popular in the Arab world and countries like Malaysia. The numbers of Islamic banks grow to 450 banks by 2009 additionally more than 300 conventional banks offer Islamic banking services to their customers.
Islamic banks have witnessed one of the fastest growth rates with assets more than doubled over the last 5 years.
Projections made by Islamic Financial Services Board (IFSB) in Malaysia, indicate that the volume of Islamic financing is expected to reach "1.2 trillion dollars by 2010 with a growth rate ranging from 15% to 20% per annum.
*Data source: The General Council for Islamic Banks and Financial Institutions in Bahrain
Islamic products, Deposits & Financing
Islamic forms of Deposits
Mudarabah is a partnership between the "Capital Provider" and the "Entrepreneur," whereby the former receives a share of the profit against his capital and the latter receives a share of the profit against his labor and management. Jurisprudence defines Mudarabah as "A contract for sharing profits by providing capital from one side and labor from the other".
Types of Mudarabah
Under this type, the Entrepreneur has the freedom of action without consultation with Capital Provider until the completion of Mudarabah Contract. This type of Mudarabah is applied to investment deposits and accounts in Islamic banking.
Under this type, the Capital Provider imposes certain conditions on the Entrepreneur to secure his capital. This type is applied to provide financing to customers. Al-Abbas, the uncle of The Prophet Mohammad, Peace be upon Him, practiced this type when he paid capital to an entrepreneur by way of Mudarabah conditioned to the Entrepreneur not travelling by sea, trade in cattle or land up in a valley, and the Prophet, Peace be upon Him, endorsed this practice.
Sectors benefiting of Mudarabah
- The Commercial Sector: through providing finance for tenders and customers with expertise. The bank fully finances the subject transaction and the client sells the goods;
- The Real Estate Sector: through providing finance for buildings construction and the customer assumes the construction works and the sale of units;
- The Industrial Sector: through providing finance for purchasing production lines and the customer following-up the operation thereof;
One of the contracts used in Islamic banks to invest deposits where the client gives the bank the authorization to invest his money in Islamic activities for a certain percentage of the capital to be deducted from realized profit.
It can also be used as a mean of Islamic finance , where the bank gives a customer the authorization to trade in a particular activity and receives a certain rate of the capital which is deducted from the profits realized and the rest of profits to the bank in return for funding.
Sectors benefiting of Wakala
- The Commercial Sector: through providing finance for customers with expertise and sharing profits according to approved percentages.
- The Real Estate Sector: through providing finance for buildings construction and sharing profits according to approved percentages.
Islamic types of Financing
Murabha is defined as "a sale at the original price plus profit" or "a sale at the capital plus a determined profit"
In Murabaha, the bank buys and owns the commodities identified by the customer, including consumer goods and production assets according to specifications determined by the customer. After assuming ownership, the bank sells these goods to the client for a price including the purchase cost plus a determined profit against the efforts exerted for the purchase and the expenses borne by the bank. The commodity is then delivered to the customer with the required specifications. The client shall pay for the commodity in periodic installments, subject to the contract of sale. "Murabaha sale" is also offered to companies by providing local or foreign raw materials, equipments and machinery with the aim of establishing and expanding production lines.
Sectors benefiting from Murabaha Sales
- The Retail Sector: through buying cars, electronic appliances and home furniture; Murabaha can also be used in financing Hajj (pilgrimage) and Omrah (minor pilgrimage) trips, club subscription fees and academic fees;
- The Vocational Sector: through buying necessary machines and equipments, especially for small enterprises;
- The Occupational Sector: through buying medical devices for hospitals and doctors;
- The Commercial Sector: through buying local or foreign ready-made goods;
- The Agricultural Sector: through buying modern agricultural machines;
- The Industrial Sector: through buying raw materials and productive equipments;
- The Real Estate Sector: through buying raw materials and construction equipments for construction companies and contractors.
In "Musharkah Financing" the client requests financing for a particular project where the bank shares the anticipated profits or losses of the project with the client. The Musharakah contract is done according to a previously arranged, mutually agreed upon set of distribution rules and principles, in compliance with Shari'a. Unlike the case of loans, in Musharkah Financing there are no interest rates.
Sectors benefiting from Musharakah
- The Commercial Sector: through sharing commercial transactions and purchase of goods and business outcomes;
- The Real Estate Sector: through sharing the construction and sale of buildings.
In general, Musharkah Financing is fit for all economic sectors as long as there is proven viability study for the project along with its expected outcome.
Types of Musharakah
Diminishing Musharakah ending with ownership
The concept of "Musharkah Financing" is based on the idea that the Bank provides the financing required by the client for a particular project without a fixed interest rate, contrary to loans. The realized financial outcome is shared between the bank and the customer as per agreed percentages.
Diminishing Musharkah that ends with ownership is one form of Musharkah where the client acquires the right to gradually replace the bank to become the sole owner of the project at one or more stages in accordance to the agreed upon conditions and the nature of the project.
Islamic banks adopted "Changing Musharakah" to provide the working capital that expanding companies may require as a substitute for providing cash liquidity. In "Changing Musharakah," the bank provides financing to the client in the form of cash that varies according to the company's needs. Actual profits are then calculated at the end of the year after finalizing the project's financial position in light of actual outcomes.
A Lease is defined as a contract that allows the customer to lease a particular asset, utilize it for a specific period of time after which it's finally to be owned. This financial lease is adopted as a result of the customer's inability to buy a particular asset in cash.
Ijara Finance ,which is a Lease with Promise of Ownership, is a financing method that distinguishes Islamic Banks from conventional Banks , through specialized companies and for helping those who cannot afford to purchase assets
Sectors benefiting of "Ijara"
- The Retail Sector: lease villas and apartments and then owing them;
- The Vocational Sector: lease machines and equipment and then owing them;
- The Industrial Sector: manufacture and lease machines and equipment and then owing them;
- The Real Estate Service Sector: lease hotels and shopping Malls and then owing them.
Istisna'a is known as a contract under which the client asks the bank manufacturing or construction of a unit not ready now with certain specifications and the bank has to meet the desire of the client and to provide that unit after manufactured according to specifications set by the client who will pay the price in installments.
Sectors benefiting of istisna'a:
- Retail sector: through the construction of housing units.
- Artisanal sector: through the manufacturing machinery and equipment.
- in arranging for vocational sector: through manufacturing specialized equipment
- Industrial sector: through manufacturing machinery and production lines.
- Real estate services sector: through the construction of hotels and markets.