ISLAMIC BANKING

WHAT ARE THE PRINCIPLES OF ISLAMIC

BANKING AND FINANCE?
• Predetermined Payments are Prohibited Any predetermined payment over and above the
actual amount of principal is prohibited. Islam allows only one kind of loan and that is qard al
Hassan (literally ‘good loan’), whereby the lender does not charge any interest or additional
amount over the money lent.

• Profit and Loss Sharing

The principle here is that the lender must share in the profits or losses arising out of the
enterprise for which the money was lent. Islam encourages Muslims to invest their money
and to become partners in order to share profits and risks in the business instead of
becoming creditors. Islamic finance is based on the belief that the provider of capital and the
user of capital should equally share the risk of business ventures, whether those are
manufacturing industries, service sector companies or simple trade deals. Translated into
banking terms, the depositor, the bank and the borrower should all share the risks and the
rewards of financing business ventures.
 WHAT ARE THE PRINCIPLES OF ISLAMIC
BANKING AND FINANCE?
• Risk Sharing
As mentioned one of the most important feature of Islamic banking is that it
promotes risk sharing between the providers of funds (investors) and the user of funds
(entrepreneur). By contrast, under conventional banking, the investor is assured of a
predetermined rate of interest. Since the nature of this world is uncertain, the results
of any project are not known with certainty ex ante, and so there is always some risk
involved.

• Emphasis on Productivity as Compared to Credit-worthiness

Under conventional banking, almost all that matters to a bank is that its loan and the
interest thereon are paid on time. Therefore, in granting loans, the dominant
consideration is the credit-worthiness of the borrower. Under PLS banking, the bank
will receive a return only if the project succeeds and produces a profit. Therefore, it is
reasoned, an Islamic bank will be more concerned with the soundness of the project
and the business acumen and managerial competence of the entrepreneur.
 WHAT ARE THE PRINCIPLES OF ISLAMIC
BANKING AND FINANCE?
• Making Money out of Money is not Acceptable
Making money from money is not Islamically acceptable. Money, in Islam, is
only a medium of exchange, a way of defining the value of a thing. It has no
value in itself, and therefore,
should not be allowed to generate more money, via fixed interest
payments, simply by being put in a bank or lent to someone else.

• Uncertainty is Prohibited
Gharar (uncertainty, risk or speculation) is also prohibited, and so any
financial transaction entered into should be free from these aspects.
Contracting parties should have perfect knowledge of the counter values
(goods received and/or prices paid) intended to be exchanged as a result of
their transactions. Also, parties cannot predetermine a guaranteed profit.
 Equity based financing
• Equity financing is the process of raising
capital through the sale of shares.

• By selling shares, they sell ownership in their

company in return for cash, like stock
financing. Equity financing comes from many
sources; for example, an entrepreneur's
friends and family, investors, or an initial
public offering (IPO).
 What are the main principles of Islamic
finance?
• Two fundamental principles of Islamic banking
are the sharing of profit and loss, and the
prohibition of the collection and payment of
interest by lenders and investors. There are
more than 300 banks and 250 mutual funds
around the world that comply with Islamic
principles.
 Equity based financing
• Under Islamic Banking there are two main fields of financing.
One is Equity Based Financing and the second is Debt Based
Financing. These modes of financing primarily differ from
conventional financing due to their voidance of interest.

• Equity Based Financing - profit-and-loss sharing (PLS)

– Musharaka (Sharing, Equity/Business partnership, Joint
Venture)
– Mudaraba (Trustee/Limited/Investment Partnership)
 Musharaka (Sharing, Equity/Business
partnership, Joint Venture)
• Two or more parties come together and contribute funds in a
partnership. Partners share in the profit or loss of a joint
venture.
• The profit-ratio is determined according to the agreement of
the partners and not necessarily according to their capital
contribution. This could depend on how much each partner
contributes to the partnership beyond their capital share.
However, the losses must be determined according to the
percentage of one’s share in the investment. Scholars agree
(Ijma’) on the equal division of loss in accordance with the
ratio of each investor.
• The profit returned to each partner should reflect the actual
profits made by the enterprise as opposed to a set income.
Partners may contribute cash or assets towards the
partnership. Their contribution ratio should be determined
according to the value of the assets.
Musharaka (Equity partnership, Joint Venture)
$2.5mil Profit

Investor $10mil (25%) 25%

A Business
Profit
Venture 10mil
Investor $30mil (75%)
B
75%

$7.5mil Profit
 Musharaka - example
Investor Contribution Outcome Outcome
1 2
Profit 200 Loss 100
A 100 (10%) 20 (10%) -10 (10%)

B 300 (30%) 60 (30%) - 30 (30%)

C 600 (60%) 120 (60%) - 60 (60%)

Profit arrangement ratio is pre-agreed at the start (10/30/60 or

it could be eg. 15/30/55) based on investors involvement in the
business management and other relevant factors (eg. experience,
skills and so on). However, loss must be shared in proportion to
contributed capital (in this case 10/30/60) and can not be
changed.
 Home purchase

• Diminishing Musharaka – This method can be used in

purchasing property or assets such as machinery for a factory.
For example, under a diminishing Musharakah contract, the
bank (or financier) and the client become partners.
• The client must provide a significant amount of funds e.g. 20%
to purchase the house with the bank. The bank in this case
owns the other 80% which the client will pay over time in
installments. Since the client will be living in the house, they
will pay (on top of the installments) a certain percentage (e.g.
8%) in rent (ijarah) to the bank for the share the bank owns.
• Over time, the client will own more equity in the house until it
is completely bought, while the rent will decrease as the
bank’s share diminishes.
Diminishing Musharaka (Musharaka Mutanaqisa)
Home Purchase
Ownership %
Bank Customer
Bank 80%↓ 20%↑
Transfer of ownership Customer
70%↓ 30%↑
Payment for piece of 60%↓ 40%↑
property (eg. 10%) 50%↓ 50%↑
40%↓ 60%↑
Rent % Rent % 30%↓ 70%↑
20%↓ 80%↑
10%↓ 90%↑
Price 80% Price 20% 0%↓ 100%↑

Bank’s participation diminishes over

time until customer becomes sole
owner of the property.
 Mudaraba (Trustee or Investment
Partnership)
• Such a contract requires one partner with the funds, known as
Rabb-ul-Mal (Owner of Wealth), and one partner is the
Mudarib (Entrepreneur, Fund Manager). There can be more
than one Mudarib to work together as partners with the Rabb-
ul-Mal.
• If the business or project is a success, the profit is shared
according to a pre-agreed ratio. Typically, the Rabb-ul-Mal
bears the risk of losing money, while the Mudarib loses time
and effort if the project does not bear fruit.
• The Rabb-ul-Mal may specify where they want the Mudarib to
invest their money (Al-Mudaraba Al-Muqayyada – specific or
restricted Mudaraba, eg. Specific type of business of place).
Otherwise, the Mudarib is free to invest where they best see fit
(Al-Mudaraba Al-Mutlaqa – unrestricted or general investment
(Mudaraba), unrestricted by time, place, activity and so on).
 Mudaraba (Investment Partnership)
Share of profits

capital
Investor
Business
Venture Profit
Mudarib management
(entrepreneur)

Share of profits

Profit can not be a fixed amount (for PLS financing) but must be determined
by a pre-agreed ratio. In case of loss, the investor loses capital and the
mudarib loses time and effort. In the case of proven negligence by the
mudarib, the mudarib may be liable for capital as well.