Islamic banking is banking or banking activity that is consistent with the principles of sharia and its practical application through the development of Islamic economics. As such, a more correct term for ‘Islamic banking’ is ‘Sharia compliant finance’. Sharia prohibits the fixed or floating payment or acceptance of specific interest or fees (known as riba, or usury) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also haraam (“sinful and prohibited”). Although these principles have been applied in varying degrees by historical Islamic economies due to lack of Islamic practice, only in the late 20th century were a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
The term Islamic banking refers to a banking activity or a system of banking that is in consonance with the basic principles of Islamic Shraiah(rules and values set by Islam). Islamic banking is also known as interest free banking system as the Shariah disallows the acceptance of “Riba” or interest rate for the accepting and lending of money. In Islamic banking system, a business that offers good interest rates or services is strictly prohibited and it is in fact considered Haraam(forbidden). Islamic banking offers the same facilities as conventional banking system except that it strictly follows the rules of Shariah or Fiqh al- Muamlat.
An early market economy and an early form of mercantilism, called “Islamic capitalism”, were developed between the eighth and twelfth centuries. The monetary economy of the period was based on the widely circulated currency the gold dinar, and it tied together regions that were previously economically independent.
A number of economic concepts and techniques were applied in early Islamic banking, including bills of exchange, partnership (mufawada, including limited partnerships, or mudaraba), and forms of capital (al-mal), capital accumulation (nama al-mal), cheques, promissory notes, trusts (see Waqf), transactional accounts, loaning, ledgers and assignments. Organizationalenterprises independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.
The word “riba” means interest, usury, excess, increase or addition, which according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). The definition of riba in classical Islamic jurisprudence was “surplus value without counterpart”, or “to ensure equivalency in real value”, and that “numerical value wasimmaterial.”
Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materialssuch as paper or base metals were allowed to have interest applied to them. When base metal currencies were first introduced in the Islamic world, the question of “paying a debt in a higher number of units of this fiat money being riba” was not relevant as the jurists only needed to be concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight).
The Origin, History and Evolution of Islamic Banking
The origin of Islamic banking system can be traced back to the advent of Islam when the Prophet himself carried out trading operations for his wife. The “Mudarbah” or Islamic partnerships has been widely appreciated by the Muslim business community for centuries but the concept of “Riba” or interest has gained very little diligence in regular or day-to-day transactions.
The first model of Islamic banking system came into picture in 1963 in Egypt. Ahmad Al Najjar was the chief founder of this bank and the key features are profit sharing on the non interest based philosophy of the Islamic Shariah. These banks were actually more than financial institutions rather than commercial banks as they pay or charge interest on transactions. In 1974, the Organization of Islamic Countries (OIC) had established the first Islamic bank called the Islamic Development Bank or IDB. The basic business model of this bank was to provide financial assistance and support on profit sharing.
By the end of 1970, several Islamic banking systems have been established through out the Muslim world, including the first private commercial bank in Dubai(1975), the Bahrain Islamic bank(1979) and the Faisal Islamic bank of Sudan (1977).