An introduction to Islamic banking

This article tells you about the basic concepts and principles of Islamic banking.

 

WHAT IS ISLAMIC BANKING?

Islamic banking is a banking based on Islamic value system and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic law (Shariah). It follows the Shariah, called fiqh muamalat (Islamic rules on transactions).

Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking in general not only avoids interest-based transactions, prohibited in the Islamic Shariah, but also avoids unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.

 

THE PHILOSOPHY OF ISLAMIC BANKING AND FINANCE

Islamic Shariah prohibits ‘interest’ but it does not prohibit all gains on capital. Islamic principles simply require that performance of capital should also be considered while rewarding the capital.

Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to
prudently handle the unique risks involved in management of assets by adhering to best practices of corporate governance.

Profit has been recognized as ‘reward’ for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits.

 

OBSERVING SHARIAH PRINCIPLES

In Malaysia an Islamic banks is required to set up a Shariah Committee to make sure that it functions in accordance with the Shariah. In addition, the advice of the Shariah Advisory Council which is the highest Shariah body set up at Bank Negara Malaysia, can be sought to ensure uniformity in views and practices. The members of the Shariah Committees and the Shariah Advisory Council are academicians and Shariah experts in Islamic banking and finance.

 

SHARIAH CONCEPTS IN ISLAMIC BANKING

The common Shariah concepts or modes (in Malaysia) are as follows:

 

1. Wadiah (Safekeeping)

Wadiah means custody or safekeeping. In a Wadiah arrangement, you will deposit cash or other assets in a bank for safekeeping. The bank guarantees the safety of the items kept by it.

 

2. Mudharabah (Profit sharing)

Mudharabah is a form of partnership where one party (investor) provides the funds/ capital while the other (entrepreneur) provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties based on a pre-agreed profit sharing ratio, while loss is borne only by the provider of the capital.

The principle of Mudharabah can be applied to Islamic banking operations in 2 ways:

• A bank as an entrepreneur and the other party as an investor.
• A bank as an investor and the other party as an entrepreneur.

Process flow:

1. You supply funds to the bank after agreeing on the terms of the Mudharabah arrangement.
2. Bank invests funds in assets or in projects.
3. Business may make profit or incur loss.
4. Profit is shared between you and your bank based on a pre-agreed ratio.
5. Any loss will be borne by you. This will reduce the value of the assets/ investments and hence, the amount of funds you have supplied to the bank.

 

3. Bai’ Bithaman Ajil – BBA (Deferred payment sale)

This refers to the sale of goods where the buyer pays the seller after the sale together with an agreed profit margin, either in one lump sum or by installment.

Process flow:

1. You pick an asset you would like to buy.
2. You then ask the bank for BBA and promise to buy the asset from the bank through a resale at a mark-up price.
3. Bank buys the asset from the owner on cash basis.
4. Ownership of the goods passes to the bank.
5. Bank sells the goods, passes ownership to you at the mark-up price.
6. You pay the bank the mark-up price in installments over a period of time.

 

4. Murabahah (Cost plus)

Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him. The bank does that for a definite profit over the cost, which is stipulated in advance.

As in BBA, a Murabahah transaction involves the sale of goods at a price which
includes a profit margin agreed by both parties. However, in Murabahah, the seller must let the buyer know the actual cost for the asset and the profit margin at the time of the sale agreement.

 

5. Musyarakah (Joint venture)

Musyarakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business venture. All providers of capital (a.k.a partners) are entitled to participate in management, but not necessarily required to do so. Profit made will be shared by the partners based on pre-agreed ratios which may not be in the same proportion as the amount of investment made by the partners. However, losses incurred will be shared strictly based on the ratio of funds invested by each partner.

 

6. Ijarah Thumma Bai’ (Hire purchase)

Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons.

It involves two separate contracts: Ijarah contract (leasing/renting) and Bai’ contract (purchase). The Ijarah contract is the first of two contracts whereby the customer leases the car from the owner (bank) at an agreed rental over a specific period. The second contract, Bai’ enables the customer to purchase the car at an agreed price after the leasing period ends. The contracts are made one after the other.

Process flow:

1. You pick a car you would like to have.
2. You ask the bank for Ijarah of the car, pay the deposit for the car and promise to lease the car from the bank after the bank has bought the car.
3. Bank pays the seller for the car.
4. Seller passes ownership of the car to the bank.
5. Bank leases the car to you.
6. You pay Ijarah rentals over a period.
7. At end of the leasing period, the bank sells the car to you at the agreed sale price.

7. Bai’ al-Inah (Sell and Buy Back Agreement)

The financier sells an asset to the customer on a deferred payment and then the asset is immediately repurchased by the financier for cash at a discount.

 

8. Wakalah (Agency)

This is a contract whereby a person (principal) asks another party to act on his behalf (as his agent) for a specific task. The person who takes on the task is an agent who will be paid a fee for his services.

Example:

• A customer asks a bank to pay someone under certain terms. The bank is therefore the agent for carrying out the financial transaction and the bank will be paid a fee for its services.

 

9. Qard (Interest-free loan)

Under this arrangement, a loan is given for a fixed period on a goodwill basis and the borrower is only required to repay the amount borrowed. However, the borrower may, if he so wishes, pay an extra amount (without promising it) as a way to thank the lender.

Example:

• A lender who lent RM5,000 to a borrower on Qard will expect the
  borrower to return exactly RM5,000 to him at a later date.

 

10. Hibah (Gift)

This refers to a payment made willingly in return for a benefit received.

Example:

• In savings operated under Wadiah, banks will normally pay their Wadiah depositors hibah although the accountholders only intend to put their savings in the banks for safekeeping

 

For more info: bankinginfo.com.my