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Islamic Banking

Posted in Finance Articles, Total Reads: 3176 , Published on October 30, 2010

At a time when the banking industry is trying to recover from the worst ever economic crisis, the Islamic Banking has stood tall and remained unaffected from the global turmoil. Islamic banking is based on Sharia Islamic law which prohibits payment or acceptance of interest fees for lending and accepting of money respectively as well as investing in business that provide goods and services considered contrary to its principles.

Following are the principles which govern Islamic banking:
• Riba: It prohibits interest in return for the lender waiting for their money as well as prohibits excessive compensation without any consideration. Examples include investments in conventional banks, investments in highly leveraged companies.
• Ghrar: Prohibition on investments based on uncertainty and ambiguity. Example includes buying a home price of which is to be determined in future is not allowed based on Ghrar.  Investment in derivatives is not allowed based on Ghrar.
• Haram: It prohibits investing in certain products and industries such as gambling, alcohol, pork, pornography and weapons.
Basically Islamic banking is based on profit sharing and risk sharing. Islamic banks evaded the crisis because Islamic banks are required to share the profits and losses of their clients, whether in business investments or mortgages, they have to be much more careful when choosing which deals to finance. This is because their financial returns would depend on the performance of the projects they have financed. Islamic banks act as investment partners for those who need money to do business and in process become part owners of the business.

Islamic Banking

The various Islamic products are:
Partnership modes
• Mudrabaha: This involves purchase of asset by the bank and onward sale of the same to the customer. This may involve purchase of commodities, vehicle, home, real estate etc. The bank makes the profit which is difference between the amount it pays to the supplier and price at which it sells to the customer. The financed amount is due and payable on terms agreed on bank and customer. Sharia principles require that the goods purchased should be owned by banks and bank bears all the risks unforeseeable until the goods are sold to the customer
• Musharakah: It revolves around partnership generally for limited duration formed to finance a project.  Both the parties enter the partnership in which both share the equity capital. Net profits and lossed are shared according to the equity share holding.
Trade Related Modes
• Murabaha: A contract between buyer and seller under which the seller sells certain specific goods to the buyer at a sale price based on cost plus agreed profit payable in cash or on any fixed future date in lump sum or by installments.
• Musawamah: It is the negotiation of a selling price between two parties without reference by the seller to cost price. It is different from murabaha in respect of pricing formula.
• Istisna’a: It is a contractual agreement for manufacturing of goods and commodities for which cash payment is made in advance against future payments. It can be used for financing of construction of house, bridges, roads and highways.
• Ijarah: It means lease, rent or wage where a property is transferred to another person in exchange of rent. Banks orders for the capital asset required for the customer against a rental agreement with him. The title remains with the bank until the maturity of the lease. On maturity asset belongs to the bank. The purchase price as well as rentals is fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.
• Mudarabah: It is a form of partnership where one party provides the capital while the other provides management and expertise. Profits are mutually decided while the losses is borne by provider of capital.

On the asset side investment can be undertaken using profit sharing modes of financing (Mudarabah and Musharakah) and fixed income modes of financing Murabahah (cost plus mark up), installment sale (medium/long term Murabahah), Istisna/ Salam (object deferred sale or prepaid sale) and Ijarah (leasing).  On the liability side, there are current accounts and investment accounts. Investment account holders are rewarded on the basis of profit and loss sharing (PLS) method and these deposits share the business risks of the banking operations.

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