What Is Islamic Banking?
What Is Islamic Banking?
What Is Islamic Banking?
of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of
the oil producing countries, received a boost due to rationalisation of the oil prices, which had hitherto
been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives
in accordance with the ethics and principles of Islam.
Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but
also others to look for ethical values in their financial dealings and in the West some financial
organisations have opted for ethical operations.
Origin
The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet
himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated
the business world for centuries and the concept of interest found very little application in day-to-day
transactions.
Such partnerships performed an important economic function. They combined the three most important
factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually
combined in one person. The capital-owner contributed the money and the partner managed the
business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider
lost his money and the manager lost his time and labour.
1946), who, in the 1930s, argued that the traditional fractional reserve banking system was inherently
unstable and should be replaced by two separate financial institutions:
1. Deposit banks, which would maintain 100% reserves. They could not fail the depositors and could
not create or destroy effective money. They would simply accept deposits.
2. Investment trusts, which would perform the lending functions of existing banks. Such companies
would obtain funds for lending by selling their own stock.
Simons' call for a distinction between the payments and portfolio functions of banks, and for 100%
reserve requirement in the former, was rejected at the time, but interest in Simons' ideas has remained.
Many reasons have been advanced for the possible instability of the traditional banking system. Simons
suggested that the basic flaw was that as a crisis develops and earnings fall, banks make loans to
increase reserves. However, each bank can do so only at the expense of other banks and thus some
banks become insolvent.
The bank failures in the U.S. during the 1980s revived interest in equity-based proposals and the
separation of the payment of deposits from the portfolio activities of banks. The proposals made were
strikingly similar to the Islamic systems now being implemented, at least on the deposit side. But the
Islamic system goes further, requiring that loans made by banks should also be equity-based.
Islamic Banks in the 20th Century
When, in the1960s, Muslim thinkers began to explore ways and means of organising commercial banking
on an interest-free basis, economists dismissed their work as wishful thinking.
But, in 1963, in Mit Ghamr, in Egypt, the first Islamic interest-free bank came into being. Mt Ghamr was a
rural area and the people were religious. They did not place their savings in any bank, knowing that
interest was forbidden in Islam. In these circumstances, the task was not only to respect Islamic values
concerning interest, but also to educate the people about the use of banking.
The following types of accounts were accepted:
a) Savings accounts
b) Investment accounts
c) Zakat accounts
No interest was paid on savings accounts, but withdrawals could be made on demand. Small, short-term,
interest-free loans for productive purposes could be made. Funds in investment accounts were subject to
restricted withdrawals and invested on the basis of profit- sharing. The zakat account attracted the official
amount of zakat.
The Mit Ghamr project was successful, as deposits increased from 1963 to 1966. The bank was cautious,
rejecting about 60% of loan applications and the default ratio was zero in economically good times. But
project was eventually abandoned for political reasons. Nevertheless, it had shown that commercial
banking could be organised on a non-interest basis.