Is Islamic Banking Truly Halal? Debunking Myths & Misconceptions
Over the past few decades, Muslims have been striving to restructure their financial systems in accordance with Islamic law and principles. The conventional financial institutions, however, are heavily reliant on interest for both deposits and financing, making this transition particularly challenging.
Initially, many believed that creating an interest-free alternative to the existing financial system would be impossible. Even after some Islamic financial models were introduced, skeptics claimed that it would be unfeasible to operate financial institutions without charging interest on principal amounts.
Nevertheless, prominent scholars worldwide have successfully developed substitutes that align with Islamic principles. Today, the products and instruments of Islamic financial institutions are structured to comply with these principles on both the liability and asset sides. (M. T. Usmani, 2007)
What is Islamic Banking?
Islamic banking is a contemporary financial system rooted in Sharia (Islamic law), emphasizing ethical finance.
It operates on principles established during the early Islamic era, promoting profit and risk sharing while strictly forbidding predetermined returns on principal amounts.
Instead of interest, it focuses on equitable transactions and investments that benefit the community, ensuring that all financial dealings are aligned with Islamic values.
What are the key principles of Islamic finance?
The basic key principles of Islamic finance are illustrated in the figure below:
1- Belief in divine guidance
Allah (S.W.T) created the universe and appointed mankind as His representatives on earth, obliging them to fulfill His commands.
These commands are not limited to beliefs and acts of worship but extend to all aspects of life, including economic affairs. Therefore, it is the duty of humans to follow Allah's guidance in economic matters as well.
2- No Interest (Riba)
This means that, in Islamic finance, it is not permissible to earn interest on loans or to pay interest on borrowed amounts.
In contrast, conventional finance requires borrowers to pay interest on loans and incentivizes depositors with interest earnings. From a Shariah perspective, both earning and paying interest are strictly forbidden.
3- No haram investments
"Haram" is an Arabic term that literally means anything that is forbidden from a Shariah perspective. "No Haram Investment" refers to the principle that money should not be invested in companies that produce Shariah-impermissible products,
such as alcohol, tobacco, and other similar goods. In contrast, conventional financial institutions often do not hesitate to invest in such companies.
4- Risk Sharing is encoureged
There is a principle in Islamic jurisprudence known as الغنم بالغرم" تعني"الربح بالمخاطرة" “,which translates to "profit comes with risk" or "gain is accompanied by loss."
This principle emphasizes that if someone seeks to earn a profit, they must also be prepared to bear any potential loss.
In contrast, conventional financial institutions often lack a mechanism for sharing or bearing losses, as they primarily operate on fixed returns and interest-based transactions.
5- Financing is based on real assets
In Islamic finance, money is invested in a manner that is linked to real assets, meaning the investor is exposed to both profit and loss based on the performance of those assets.
In contrast, conventional financing is typically based on a promise to pay, often detached from real assets, which can result in fixed returns regardless of the underlying asset's performance.
How do Islamic banks generate profit without charging interest?
Islamic banks generate profit without charging interest by offering a variety of Shariah-compliant products, such as Ijarah, Murabaha, Mudarbah on term deposits and savings accounts, Diminishing Musharakah, and financing through Shariah-screened mutual funds.
In these products and transactions, Islamic banks are exposed to both profit and loss, while ensuring compliance with Islamic principles, and they do so without relying on interest-based mechanisms.
What are interest-free loans in Islamic finance?
There are many types of interest-free loans in Islamic finance but below some commonly used loans are:
1- Murabaha
Murabaha is a type of sale where the Islamic financial institution acts as the seller of goods, disclosing the cost plus profit margin in the contract. The client pays a portion upfront, with the remaining amount paid in installments over a deferred period.
Read more about: Your Basic Guide to Murabaha
2- Financial Lease
A financial lease is a type of lease in which an Islamic financial institution acts as the lessor, and the client acts as the lessee. In this arrangement, the financial institution provides the car or property on lease to the client,
who then pays the lease amount in installments. At the end of the lease term, the client may become the sole owner of the car or property through the execution of a gift deed, or by purchasing it for a nominal value.
3- Diminishing Musharaka
Diminishing partnership is a type of Islamic finance arrangement in which the asset is jointly owned by a financial institution and a client in a specific ratio (e.g., 70:30).
The ownership is divided into units, with the institution’s portion leased to the client. The client makes rental payments on the leased portion, and over time, as agreed upon, the client gradually buys out the institution’s share of the asset.
The client’s payments typically consist of both rent and a purchase installment. With each installment, the client’s ownership of the asset increases, and the financial institution’s share diminishes until the client fully owns the asset.(M. I. A. Usmani, 2015)
Read more about: Pros & Cons of Musharaka Contract
Is there a difference between Islamic banking and Islamic finance?
Yes, Islamic finance refers to the entire financial system within Islamic financial institutions, which operates in accordance with Shariah principles, governing all types of financial transactions.
On the other hand, Islamic banking is a subset of Islamic finance that specifically pertains to banking services and operations, ensuring they align with Islamic laws and ethical standards.
What are common misconceptions about Islamic Banking?
Some misconceptions about Islamic banking among jurists include:
- A financial penalty charged is considered interest.
- The interest rate is standardized for financial transactions.
- Takaful (insurance) is applied in car leasing and home financing.
- Profit is distributed among account holders on a daily basis.
How does Islamic Bank support ethical investment?
Islamic banks support ethical investment by adhering with Shariah principles, social justice, fairness and avoidance of all Shariah non-compliant factors, and their practical performance is:
i- Prohibition of Shariah-forbidden (Haram) activities
Islamic banks avoid investing in firms or companies that produce or deal in products considered haram (forbidden) under Shariah law, such as alcohol, tobacco, and gambling-related products.
This aligns with Islamic ethical guidelines that prohibit involvement in activities deemed harmful or unethical..
ii- Profit and loss sharing
Islamic banks engage in transactions where the profit and loss are transparently agreed upon by both parties in advance, ensuring fairness and avoiding any inequality in profit and loss sharing.
This approach aligns with Shariah principles, which emphasize justice and mutual consent in financial dealings..
iii- Asset-backed transactions
Islamic banks invest in avenues where transactions are asset-backed, ensuring they are tied to the real economy and not based on speculation.
v- Social Responsibility
Islamic banks fulfill social responsibilities by investing in sectors like health and education to enhance social well-being. (Shariah governance standard no:7 Corporate Social Responsibility).
How does Islamic banking differ from conventional banking?
Islamic banking differs from conventional banking in several key aspects. First, from a mission and objective perspective, Islamic banking is deeply rooted in Islamic principles, where moral values and ethical considerations play a central role in its operations.
In contrast, conventional banks primarily focus on profit maximization without necessarily adhering to such ethical constraints.
Second, Islamic banks are more aligned with risk-sharing than conventional banks. They operate on risk-bearing financial instruments, where both the bank and its clients share the financial risks and rewards, unlike conventional banks that often operate on debt-based interest models that transfer risk solely to the borrower.
Third, Islamic banks have a dedicated Shariah governance framework. This framework includes various departments and committees that ensure the bank's transactions comply with Islamic law (Shariah) principles, providing an additional layer of oversight and ethical compliance not typically found in conventional banks.
What is the role of profit-sharing in Islamic finance?
The profit-sharing mechanism is central to Islamic finance, where both the financial institution and the client share risk according to their respective contributions to the assets. Profit is distributed based on a pre-agreed ratio at the time of contract, below are some important rules:
i- It is not permissible for any partner to fix a fixed amount of profit in advance.
ii- A partner who actively works may receive a larger share of the profit than their capital ratio, regardless of whether other partners are working.
iii- If a partner agrees to be a "sleeping" partner and not contribute actively, their profit share cannot exceed their investment share.
However, according to the Hanbali school of thought, a sleeping partner may be allowed to receive a profit share greater than their capital contribution.
References:
1.Usmani, M. I. A. (2015). Maktaba Ma’ariful Quran (Quranic Studies Publishers). 342.
2.Usmani, M. T. (2007). To Iu. An Introduction to Islamic Finance.
3.https://citeseerx.ist.psu.edu/document
4.https://books.google.com.pk/books?hl=en
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.