What is Islamic banking and how does it work?
Religion may not be the first thing that comes to mind when you think about finance, but the two are completely intertwined when it comes to Islamic banking, or Sharia finance. 2015 statistics show that over 24% of the world’s population, or 1.8 billion people, are Muslim, and this market is quickly growing.
How islamic banking works?
But what’s so special about Islamic banking? How is it different from conventional banking? And can non-Muslims participate? Let’s go over the basics now.
What is Islamic banking?
To put it simply, Islamic finance is based on Islamic law, which prohibits giving and receiving interest (riba) when you lend money. Islamic financial activities also can’t be used for activities forbidden by Islam, such as gambling or alcohol.
According to the Institute of Islamic Banking, this kind of banking has been around since ancient times, but only in the late 20th century has a number of Islamic banks formed to service Muslims and non-Muslims alike.
How do Islamic banks earn money?
Conventional banks earn money by charging interest, but because this is forbidden in Shariah law, Islamic banks use an asset-based risk-sharing system to earn a profit. Members pool together their funds, and profits made from the investment of these funds are shared among the depositors.
When a business takes out a loan from an Islamic bank, it doesn’t give the bank interest, but instead, a share of its profits. If the business doesn’t make any profit, or if it defaults, then the bank gets nothing.
How can you borrow money from an Islamic bank?
Let’s say you want to buy a house. You could purchase property with either an ijara wa iktina or murabaha scheme:
- Ijara wa iktina: is basically rent-to-own. You pay rent to the bank over a certain period of time until the ownership is transferred to you.
- Murabaha: the bank buys your house from the seller, then re-sells it to you with a set profit. You can pay for it in instalments if you want. The price does not change even if your payments aren’t on time. The bank risks not making a profit if you don’t make your payments or if you decide not to purchase the house after all.
Can non-Muslims use Islamic banking?
Yes. In fact, because of its strict lending policies, non-Muslim investors see Islamic finance as a less risky alternative to Western finance.“Islamic banking is getting a firmer foothold in the market right now and it has attracted not just Muslims but also non Muslims not just in Malaysia but in the other parts of the world as well,” OCBC Al-Amin Bank’s chief executive Syed Abdull Aziz Syed Kechik told Reuters in 2008.