What sets Islamic banks apart from other banks? (Shariah Laws-DUH!)

Mr. Salim Abdalla, CEO of Gulf African Bank

March 19, 2008: Recently, two Islamic banks were licensed by the government to carry out operations in Kenya, with one of them, the First Community Bank already in active practice.  What sets Islamic banking apart from conventional banking as we know it?

Islamic finance is a system of banking that is guided by Islamic law and Islamic economics. Islamic finance is set on three main principles founded on Islamic Sharia law.

Islamic finance is equity based financing whereby the lenders practice a lot of equity in their dealings with clients.

 Further to this, Islamic finance prohibits investment in businesses that are considered unlawful ( haraam) such as businesses that sell pork or alcohol.
Islamic financial institutions are required to have a religious committee made up of religious scholars. The board has a supervisory and consultative duty to ensure that the bank’s practices are in line with Sharia law.

Islamic banks prohibit all sources of unjustified enrichment and prohibit the institutions from dealing in transactions that contain excessive risk or speculation.

The first principle of Islamic banking is the prohibition of interest. Interest (riba) represents a prominent source of unjustified advantage which is contrary to Sharia teachings.

Islamic banking is also founded on the notion of profit and loss sharing between the customer and the bank. The relationship between the bank and its clients is such that the two share profits and losses on the basis of their capital share and effort.  

Muslims do not act as nominal creditors in any investment but rather as partners in the business. Finally any investment that involves uncertainty and speculation ( gharrar) is prohibited. Parties to a financing contract must have knowledge of the subject matter of the contract and its implications before financing is approved.

A number of financing techniques are used including mudaraba. Mudaraba is a form of trust whereby one partner provides the capital for the project ( rab ul amal) while the other party known as mudarib, manages the project.

Profits from the investment are then distributed using a fixed ratio. Management of the investment is the sole responsibility of the mudarib while the assets acquired for the project, are owned by the financier. Mudarab may be practised by the bank as the mudarib and the depositors as the rab ul amal.

Cost plus financing is a common financing technique used by Islamic banks whereby the bank agrees to buy an asset from a third party at the request of the client and then re-sells the goods to its client at a mark up profit.

The profit made by the bank caters for the services that the bank provides thereby offsetting any benefits to the bank.

Ijara (leasing) is defined in sharia law as the sale of the right to use goods for a specific period. Ijara is a contract where the bank buys and leases out an asset or equipment required by its client for a rental fee. The ownership of the asset remains with the bank.

Modern Islamic banking was pioneered in Egypt in the 1960s and is today a common mode of financing especially in the Middle East and Europe.