Is Islamic Banking Really Islamic?

During my more than a year experience working with both Islamic banking and conventional banking, I've noticed that the key difference appears to lie in the terminology rather than the substance. Conventional banks use interest rates, while Islamic banks use profit rates. Similarly, while conventional banks charge late penalty charges, Islamic banks often deduct these charges under the guise of charity, albeit at a higher rate. At the core of this practice is the claim that conventional banking can be 'Islamic' with a simple name change.

Understanding the Principles of Islamic Finance

These claims aside, the fundamental principles and processes of Islamic finance revolve around the stringent rules of Sharia law. True Islamic finance must follow these rules:

Paying or Charging an Interest (Riba)

Islamic finance explicitly prohibits lending with interest payments. Interest is considered usury, or riba, which is strictly forbidden under Sharia law. This exploitative practice favors the lender and is therefore unacceptable in Islamic finance.

Prohibited Activities and Investments

Islamic finance also prohibits investing in businesses involved in prohibited activities. Any involvement in the production and sale of alcohol or pork, for instance, would be considered haram or forbidden. Investments in such activities are likewise forbidden.

Speculation (Maisir) and Uncertainty (Gharar)

Islamic finance strictly prohibits any form of speculation or gambling, which is called maisir. This includes any contract where the ownership of goods depends on an uncertain future event. Additionally, transactions with excessive risk or uncertainty, measured by the term gharar, are also forbidden, particularly in derivative contracts and short-selling.

Profit/Loss Sharing

At the core of Islamic finance lies the principle of profit/loss sharing. In Islamic banking, each transaction must be related to a real underlying economic transaction. More importantly, both parties share the profit or losses associated with the transaction. No one can benefit more than the other, embodying the principle of shared risk and reward.

Permissible Financing Arrangements

To practically implement these principles, Islamic finance utilizes various permissible financing arrangements, such as:

Mudarabah - Profit and Loss Sharing Contracts

Here, an Islamic bank pools investors' money and assumes a share of the profits and losses. The bank and investors agree on the division of risks and rewards. This arrangement often involves a group of mutual funds screened for Sharia compliance, where company balance sheets are thoroughly analyzed to ensure that any sources of income are not prohibited. Companies that are heavily in debt or engaged in forbidden businesses are excluded.

Declining Balance Shared Equity

This arrangement involves the bank and the investor purchasing a home jointly. The bank gradually transfers its equity in the house to the individual homeowner. The homeowner's payments gradually transform into the homeowner’s equity. This method is commonly used to finance home purchases and is a viable alternative to conventional home loans.

Ijarah - Leasing

Ijarah involves selling the right to use an object for a specific time. The lessor must own the leased object for the duration of the lease. A variation, called ijara wa iqtina, involves the lessor agreeing to sell the leased object at a predetermined residual value at the lease's end. The lessee is under no obligation to purchase the item.

Installment Sale - Murabaha

Murabaha, or an installment sale, involves an intermediary purchasing a home with a clear title and then selling it to the buyer at a predetermined price, including a profit margin. This sale can be made in a single lump sum or through deferred installment payments. Unlike an interest-bearing loan, this credit sale is an acceptable form of finance.

Ijara - Leasing

Leasing in Islamic finance is slightly different from conventional leasing. The key principle is to sell the right to use an asset, not to transfer ownership. The lessor must own the leased object throughout the lease agreement. At the end of the lease, the lessee has the option to buy the asset at a price agreed upon beforehand.

Islamic Forwards - Salam and Istisna

These are rare forms of financing used for specific business needs. These forms of financing are exceptions to the rule of gharar because the conditions are clear and the delivery of goods is guaranteed. Contracts of this nature require the involvement of an Islamic legal advisor to ensure their validity.

For true Islamic finance to be 'Islamic,' it must adhere to the above principles and arrangements, reflecting a genuine commitment to Sharia law. Simply employing new terminology does not transform conventional banking into genuine Islamic finance.

Keywords: Islamic banking, Sharia law, permissible financing