Islamic banking is a banking system based on the principles of Islamic law (also known as Shariah) and guided by Islamic economics. All the undertakings of the banks in the system follow Islamic morals, so it could be said that financial transactions in the system are a culturally distinct form of ethical investing.
Ahmad El Najjar led the first modern experiment with Islamic banking in Egypt in 1963, which was in the form of a savings bank based on non profit sharing. The pioneering effort was under cover and did not project an Islamic image because of concerns that it might be seen as manifestation of Islamic fundamentalism, which was anathema to the political regime. The experiment lasted until 1967 and by that time there were nine such banks across the country. These banks were essentially saving-investment institutions rather than commercial banks.
In the 1970s, Islamic financial institutions did not have to be established under cover as the political climate of many Muslim countries changed. A number of Islamic banks were established in the Middle East. Dubai Islamic Bank, established in 1975, was the first full-fledged Islamic bank in the world. Later, a number of such institutions were formed in countries where Muslims are a minority. The Islamic Banking System, established in Luxembourg in 1978, represents the first Western attempt at Islamic banking.
The main feature of Islamic banking is that it is based on the fact that the institution of interest has no place in the Islamic order. Islam prohibits Muslims from taking or giving interest (or riba), regardless of a loan's purpose and the rates at which it is charged. So in Islamic banking the collection and payment of interest is prohibited.
However, profit-sharing is permissible in Islam, because only the profit-sharing ratio is predetermined rather than the rate of return itself. Hence, the owner of capital has the legitimate right to share the profits made by the entrepreneur. Some have suggested that profit-sharing can be a viable alternative to the interest rate mechanism.
The owner of capital (rabbul-mal) may "invest" by allowing the use of his capital by an entrepreneur with ideas and expertise for productive purposes and then may share the profits with the entrepreneur-borrower (mudarib). However, if there are losses, the rabbul-mal will bear the all. This mode of financing is called mudaraba in Islamic literature.
Mudaraba is one of the pillars of Islamic banking. The other is musharaka, which is a mode of financing based on equity participation. In this mode, the partners use their capital jointly in a bid to generate a surplus. They will share the profits or losses on the basis of an agreed formula, depending on the equity ratio. The musharaka principle is similar to the concepts of partnership and joint stock ownership and is invoked in the equity structure of Islamic banks.
Islamic banks operate a two-tier mudaraba system under which a bank acts both as the mudarib when it comes to savings and as the rabbul-mal on the investment portfolio side. Such institutions typically operate three broad categories of account, mainly current, savings and investment accounts. The current account is essentially a safe-keeping (al-wadiah) arrangement between a depositor and the bank, allowing the depositor to withdraw his or her money at any time and permitting the bank to use the depositor's money.
The savings account also operates on an al-wadiah basis, but the bank may pay the depositor a positive return periodically, depending on its profitability. Such a payment is not a condition for lending by the depositors to the bank and is not predetermined, so is considered lawful in Islam. The investment account is based on the mudaraba principle, while the deposits are term deposits and cannot be withdrawn before they mature. Different banks offer a different profit-sharing ratio, which also depends on the supply and demand conditions.
Islamic banks employ a variety of instruments for investment, preferring less risky modes of financing. The most commonly used one is the "mark-up" device, which is called murabaha. Under the transaction, the bank buys a good or asset on behalf of a client and adds a mark-up before reselling it to the client on a "cost-plus" basis. Islamic banks also purchase and sell properties on a deferred payment basis, a process called bai' muajjal. Another frequent practice of Islamic banks is leasing, or ijara, as part of which they purchase the equipment or machinery and lease it out to a client who may buy the items eventually.