Principles

Islamic banking has the same purpose as conventional banking except that it operates according to the rules of Shariah, known as fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profits and losses and the prohibition of riba (usury). The common terms used in Islamic banking, including profit sharing (Mudharabah), storage (Wadiah), a joint venture (Musharakah), cost plus (Murabahah) and leasing (Ijarah).


In an Islamic mortgage transaction, instead of lending money to the buyer to purchase the item, a bank may purchase the item itself from the seller, and re-sell to the buyer at a profit while allowing the buyer to pay the bank in installments. However, the profit of the bank can not be explicit and therefore there are no penalties for late payment. To protect itself against default, the bank requires strict safeguards. The property or land is registered in the name of the buyer from the start of the operation. This arrangement is called Murabaha. Another approach is EIjara wa EIqtina, which is similar to leasing real estate. Islamic banks handle loans for vehicles in a similar way (selling the vehicle to a higher than market price for the debtor and the maintenance and ownership of the vehicle until the loan is repaid).

A novel approach applied by some banks for home loans, known as al-Musharaka Mutanaqisa, allows a variable rate in the form of rent. The bank and the borrower as a partnership entity, both providing capital at a percentage agreed to buy the property. The partnership entity then leases the property to the borrower and charges rent. The bank and the borrower will then share the proceeds of the rent based on the equity portion of today's society. At the same time, the borrower entity in the partnership also buys the bank of the property agreed to payments until the total net worth has been transferred to the borrower and the partnership is ended. If failure, the bank and the borrower receives a share of proceeds from the sale of the property based on equity in each party. This method allows for variable rates depending on the current market rate such as the BLR (base rate), especially in a dual-banking, as in Malaysia.

There are several other approaches used in commercial transactions. Islamic banks lend money to companies by issuing loans at variable interest rates. The variable interest rate is indexed to the individual rates of return to society. Thus profit from the bank on the loan is equal to a percentage of company profits. Once the principal amount of the loan is repaid, the sharing agreement is entered into profits. This practice is called Musharaka. In addition, Mudaraba financing is venture capital for an entrepreneur who provides labor while financing is provided by the bank so that the benefits and risks are shared. Such participatory arrangements between capital and labor reflects the Islamic point of view that the borrower must not bear all the risks and costs of failure, leading to a balanced distribution of income and not allowing lender to monopolize the economy.

Islamic finance is restricted to Islamically acceptable transaction, which exclude those involving alcohol, pork, gambling, etc. The aim is to engage only in ethical investment and purchasing entity.

In theory, Islamic banking is an example of full reserve banking, with banks achieving a rate of 100% reserve. [21] However, in practice this is not the case, and no examples of 100 percent reserve banking are observed. [22]

Islamic banks have recently increased in the Muslim world but are a very small share of the global banking system. Microfinance institutions, credit founded by Muslims, notably the Grameen Bank use conventional lending practices and are popular in some Muslim countries, including Bangladesh, but some do not consider the true Islamic banking. However, Muhammad Yunus, founder of Grameen Bank and microfinance bank, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-credit is compatible with the Islamic ban usury (riba).