Introduction to Islamic Banking

Introduction to Islamic Banking

The most distinguishing characterize of the Islamic economic system is the prohibition of interest. Islamic economic principles have prominently been applied in financial industry especially in banking. Islamic Finance is growing in multiple dimensions and is now spreading in other financial sectors like insurance, structured finance, project finance, mutual funds, syndicated finance, investment banking etc. On the geographical level too, Islamic banking has grown from Middle East to Europe and now is well positioned in South Asian markets in addition.

Shariah compliance also ensures Corporate Social Responsibility (CSR) and ethical compliance. Islamic edges do not conduct business with companies producing tobacco, alcohol or engaged in business of gambling, casino, nightclubs, prostitution etc. This mechanism has given Islamic banking the name of ‘ethical banking’ in Europe.

The balance sheet of Islamic edges is capable of taking financial shocks. Islamic edges are not obliged to give fixed return to their depositors and general creditors. The creditors, shareholders and depositors proportion and participate in the bank’s business. consequently, if incase, there is a shock on asset side (NPL increasing), Islamic edges will be able to proportion this loss with their depositors and shareholders.

Islamic edges cannot rollover loans. consequently, the packaging and repackaging of loans and then issuing more and more debt securities on the back of these non performing loans cannot legally happen in Islamic edges. Islamic edges are obliged to have backing of assets in all their investments. consequently, Islamic edges losses already theoretically cannot go beyond the value of the real asset.

Financing Operations of Islamic edges

For the provision of finance, following modes are used in Islamic banking.

Diminishing Musharakah

In Diminishing Musharakah, the customer approaches the bank for joint buy of an asset/character. It is referred to as ‘Diminishing Musharakah’ because the ownership stake of the tenant increases and that of the bank decreases or diminishes with the passage of time. The rent decreases as the ownership stake of tenant increases. The proportion of the bank in asset/character is divided into units. These units are purchased by the customer regularly until he has purchased all the units. After the customer has purchased all the units of the bank, he becomes the only owner of the asset/character.

Murabaha Muajjal

Murabaha is a deferred payment sale transaction. Murabaha is used in working capital financing, SME financing and trade financing. the time of action flow of Murabaha is as follows:

Islamic bank and the client sign a Master Murabaha Finance Agreement and an agency agreement. According to the agency agreement, the customer purchases goods from the supplier on bank’s behalf. The customer undertakes to buy the asset from the bank. It is a one-sided potential and undertaking. The bank pays the supplier and obtains title and physical/constructive possession of the asset. The customer signs a declaration that he has purchased the goods on bank’s behalf and now he is willing to buy the asset. After offer and acceptance, sale is executed and the customer pays the agreed price to the bank.


Ijarah method to give something on rent. In Ijarah, right of use of a character is transferred to another person for a consideration. the time of action flow is as follows:

The customer approaches the bank for obtaining an asset on lease. The customer undertakes to make regular lease payments for the lease period. Lease agreement and agency agreement is signed. The customer as an agent to the bank buys the asset. Bank receives the title of the asset and pays the vendor. The bank leases the asset and the customer starts using the asset and pays rent for each period. In the end, the customer can buy the asset from the bank by way of a separate buy agreement.


It is used in financing goods and sets that are not ready for identify sale and will have to be delivered later. In Salam, payment is identify, but the delivery is deferred. It is used in special situations to ease transactions. In current practice, it is used in money trade as an different for bill of exchange discounting and in agriculture financing.


It is used in financing goods that are not however ready for sale and will have to be manufactured. Example includes tailoring sets, architect sets etc. It is an order to producer to manufacture a specific commodity for the purchaser. It is used in pre-shipment exports financing and usable in all other situations where goods have to be manufactured before sale.

place Side Operations of Islamic edges

The two main categories of deposits are checking accounts and non-checking accounts. Some accounts are remunerative and some are non-remunerative. For offering place products, following modes are used in Islamic banking.

Non-Remunerative Accounts

Current Account is an example of a non-remunerative checking account. The money deposited in such account is considered ‘Qard’ (Non-interest bearing loan). The money is invested in the fund by the bank. Bank utilizes the money to invest in Ijarah, Murabaha, Diminishing Musharakah, Salam, Istisna etc. The money is payable on need.

Remunerative Accounts

Remunerative accounts can be checking i.e. Savings Account or non-checking accounts i.e. Term Deposits. The money is invested in the fund. The bank acts as ‘Mudarib’ i.e. ‘Fund Manager’ and the customer acts as ‘Rabb-ul-maal’ i.e. ‘investor’.

The money is only invested in Shariah compliant assets. Bank utilizes the money to invest in Ijarah, Murabaha, Diminishing Musharakah, Salam, Istisna etc. The Weightage is stated to each category of investment that is stated to the customer at the outset. Profit is declared at the start of the month for the past month based on the weightage before announced. Profit is paid out of the actual Gross Income.

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