The term ‘Islamic banking’refers to a banking system or activity that is based on the principles of Islamic law (i.e. Sharia) and where all banking operations follow Islamic morals. The basic principle that distinguishes Islamic finance from the others is its prohibiton of the collection and of payment of interest (riba). Moreover, in this type of bank, not all investments are allowed. For instance, placing an investment in an alcohol or gambling company would be contrary to the Sharia and thus forbiden by the bank.
Because collecting interest is forbidden by the Islamic laws, these banks use other financial instruments to make money. As such, when granting a mortgage, islamic banks do not lend money but rather purchase the item and resell it to the client at a profit. Nevertheless, there are no additional penalties for late payment. In fact, if there are penalties, the amount charged by the bank must be given to Charity.
The practice of Mujarak which means partnership is another alternative for companies seeking loans. This instruments requires pegging a floating rate to a company’s individual rate of return. The price of the loan (paid in monthly instalments) depends on the company’s own profits and stands as one of the biggest principles of Islamic finance which is sharing both the gains and the losses.
Investment banks can only invest in real assets. As such, financial instruments based on speculation (such as derivatives) are not allowed in this system. According to the Guardian, “there is some common ground to compare Islam finance with ethical banking” as both share the principles of equitable distribution and fair trade.
Although the existence of this financial services surprises many, according to PWC, global islamic financial assets were valued at USD 2 trillion in 2012. While Iran has traditionally been the largest market, this system is also extremely important in Malaysia, Kuwait, Saudi Arabia and in the United Arab States.