Islamic banking signifies a composition of banking that is consistent with the doctrine advocated by the Sharia law. The Sharia law concerns Islamic rulings that are suggested in the Quran, the sacred text of the Muslims. In Islamic banking, these rules and regulations are applied practically in the development of Islamic economics (Chapra 1985). The doctrines, which accentuate honourable and fair play, are venerated throughout the world. Shariah forbids the imbursement or reception of interest, (riba), for the giving and accepting of cash. It also prohibits the act of trading in goods and services that go against its main beliefs. Most of these values were used as the basis for the creation of thriving economies in bygone eras. In the late 20th century, the authorities who deeply believed in this method of doing things came together to provide a different method of banking for conservative Muslims. However, this mode of banking is not restricted only to Muslims. Non-Muslims are welcome to use it if they so desire.
Islamic banking has the same objectives as conventional banks with the simple difference that it operates in accordance with Fiqh al-Muamalat (Islamic laws that govern business transactions). These principles were implemented in various capacities in the past in Muslim led nations. Their original shape, however, has been transformed through the centuries. The main foundation of the Sharia decrees is the Quran. The Sharia rules are also based on the confirmed adages and deeds of the Prophet Muhammad, the hadith. Concerning problems whose answers cannot be found within any of these two resources, judgements are made founded on the agreement of the Islamic intellectuals of the community. The rulings of these intellectuals should not depart in any way from the elementary teachings of the Quran.
The modern Islamic bank was operational at the inception of Islam when the prophet Muhammad acted as an agent in the commercial transactions concerning his wife’s business. Islamic joint ventures, Mudarabah, would dominate trade transactions and the concept of interest was hardly recognized. Such partnerships had a significant trade and industry purpose. They united three vital aspects of business, investment, manual labour, and free enterprise. An investor would contribute the capital to initiate the business, while his partner would manage it and supply the workers if it was necessary. Each of these business partners shared in a pre-discussed split of the profits. If loss was encountered, both suffered as the investor’s capital was squandered while the manager lost his time and workforce.
The safekeeping of money and precious goods is a practice that endured in the Arab world over many centuries. In Prophet Muhammad’s day, people would deposit their savings with those who were known as trustworthy ones in the society. When they had an urgent need of their money, they would get it back in the same form without all manner of interests being fostered on them. Zubain Bin Al-Alam, a friend of Prophet Muhammad, was one of the few individuals who enjoyed a reputation for dependability. He preferred to keep money for people in the form of credit and not deposits. This is because he wanted to acquire the right to dispose of money to certify reimbursement for the owner. Money that remains idle in any banking institution will bring some losses to its owner. However, when a deposit is converted into a loan, it is protected, as it becomes the legal responsibility of the borrower.
Legalization of Interest
The High Middle ages, (1000-1350), saw a rise in commercial enterprises in Italy. Banking activities spread from Italy to the rest of Europe and were progressively more concerned with credit transactions. In the thirteenth and fourteenth centuries, there were intercontinental merchant banks, limited deposit banks, and pawn broking institutions in existence. Before 1546, the ruler of England, King Henry III, authorized the Jews to charge 43% interest on annual loans. The determination of the interest rate limit was intended to calm the anxiety of the public. Additionally, it also allowed the Jews to charge 43% interest on loans. The ratification of this rule was a blatant shot at legalizing the charging of interest. The Church had long since prohibited this practice. The decree was passed under pressure of the rich merchants who were the chief beneficiaries. The merchants bribed the British parliamentarians and paved the way for the governmental recognition of interest. This was one of the first steps towards the official introduction of an interest driven banking organization (Thomas, Cox & Kraty 2005).
This produced a constructive setting for the realization of profits and incited other societies to rush into this lucrative field. The British jewellers took advantage of new trade prospects and began lending cash at considerable interest. They presented small rates of interest in comparison with other merchants. After the confirmation of interest, the merchants created mercantile banks on the model of joint stock corporations. They were hidden behind the banks by institutionalizing the collection of interest. This saved them from the anger of those who revolted against the practice of charging high rates of interest in the majority of European countries.
Trade Banks in Muslim Lands
Western commercial banks were dated from about two hundred and fifteen years ago. When the Muslim populations met the west, Muslims had two alternatives:
- To acknowledge commercial banking, disputing that the interest required did not include the aspect of riba, which is forbidden in the Qur’an
- To allow that the interest that was demanded was riba. This would mean attempting to create a different type of banking.
Ancient Muslim establishments, such as the Shari’ah magistrates, had been made futile by the colonial authorities. Muslims had no option but to labour with the colonial organizations, such as commercial banks. Nonetheless, at some stage in the 19th century, numerous spiritual scholars disputed that the phrase riba meant loans for expenditure, which many individuals found complicated to repay. The scholars established that riba was not a reference to credit from commercial banks, which a defaulter can reimburse from the proceeds. The Qur’an makes no difference between credit for expenditure and advances for industrious functions. Consequently, the observations of the Muslim intellectuals were ignored. Consequently, contemporary commercial banking did not make much progress in Muslim nations. To the present day, the conventional outline of interest driven programmes still directs the public financial scheme.
Early Western PLS Proposals
Equity-participation themes had been anticipated at various times of financial emergencies in the United States and Latin America. The most enthusiastic advocate of these was American financial expert, Henry Simons (1899 – 1946). In the 1930s, he claimed that the conventional partial reserve banking coordination was intrinsically unsound. He wished it to be substituted by two divided economic establishments:
- Deposit banks: These would preserve 100% of deposits. They could neither fail the depositors nor generate or wipe out valuable money. They would merely receive deposits.
- Investment trusts: These would carry out the loaning purposes of active banks. Such corporations would attain finances for lending by trading on their own stockpile.
Simons called for a division between the outflow and the assorted purposes of banks. He also championed the 100% reserve requirement in the former. This proposal was discarded at the time, but curiosity about Simons’ ideas has lingered. Many explanations have been advanced for the probable volatility of the conservative banking system. Simons recommended that the essential flaw be that when a crisis builds up and earnings drop, banks would advance credit to boost reserves (Durrani & Boocock 2006). However, each bank can do so only at the cost of other banks and so some financial institutions become bankrupt. The bank crashes in the U.S. throughout the 1980s rejuvenated interest in equity-based suggestions. They also aroused some interest in the division of the disbursement of deposits from the assorted functions of banks. The suggestions made were markedly comparable to the Islamic structures now being executed, as far as the deposits are concerned. However, the Islamic system goes further. It stipulates that credit advanced by financial institutions should also be equity-based.
In 1963, in Mit Ghamr, Egypt, the first Islamic interest free bank was created. In such a rural and conservative Islamic community, the citizens were not prepared to deposit money in banks that dealt with interest as these contravened the rules of the Quran. In the newly created bank, no interest was paid on savings accounts even though withdrawals could be made on demand. Small, interim, interest free loans could also be made for productive purposes. Funds in investment accounts were subject to restricted withdrawals and invested on the premise of profit sharing.
The Mit Ghamr project was successful and deposits were continually achieved from 1963 to 1966. In spite of its success, the project was finally abandoned due to political complications. A well-known conviction endures that Islamic banking is an interest free monetary arrangement. Islamic economics, however, embraces an all-encompassing system of community and trade and industry impartiality. It concerns land rights, the motivation system, allotment of assets and financial freedom. It also delves into decision-making and the proper role of government. The Quran states, “God has permitted business, but prohibited riba (interest)”. Returns on savings are not the only interest forbidden, but an uncertain rate of return that will bring profits is also prohibited.
Islamic Banking Principles
The Shari’ah forbids the imbursement of costs for the leasing of cash (riba, which in explanation of Islamic intellectuals covers any surplus in financial transactions, usury or interest). The Sharia also prohibits the practice of participating in trades that supply commodities or services going against its principles (Haram). While these values were utilized as the foundation for a flourishing economy in bygone times, it is only in the late 20th century that such notions were revived within the Muslim community (Di Vanna 2006).
While a fundamental necessity in Islamic banking is the banning of riba, it has rarely been acknowledged as appropriate outside the Islamic world. Many of its guiding values, however, are embraced in other banking establishments. The bulk of these doctrines are founded on straightforward decency and common sense. The universal character of these principles is directly apparent even at a passing glimpse of non-Muslim literature. Usury was outlawed in both the Old and New Testaments of the Holy Bible. Although the western mass media sources regularly imply that Islamic banking in its current structure is a new trend, this is far from the truth. The essential exercises and values were dated back to the initial years of the seventh century.
Theoretical Basis for Islamic Banking
An accepted conviction that Islamic banking is only an interest-free economic organization endures. Islamic money matters comprise a total arrangement of societal and fiscal justice. It concerns property rights, the motivation system, the allotment of assets, financial liberty, administrative judgement and the proper role of government. Therefore, it is only the preset, or predestined, earning on investments or business dealings that are outlawed (Hanif 2011). The uncertain rate of return, such as the making of profit, is not forbidden.
Modern Justifications for Interest
Contemporary financial experts have created many opinions to validate interest. One opinion is that the interest is the compensation for hoarding financial resources. The creditor gives a reimbursement to the debtor for the latter’s provisional loss of the exploitation of funds. An additional one is that the interest is the compensation for the loss in worth of currency owing to price rises. The merchandise that the saver desires will be worth more in the future, so he is vindicated in demanding a rent for the employment of his loan. John Maynard Keynes (1883-1946) disputed that currency is the most liquid of resources. He maintained that it is the resource being most voluntarily preferable in exchange with other forms of assets. Keynes also believed that interest is the cost remunerated for the loss of liquidity. The speculation that interest guards savings from price increase does not clarify why the rate of interest is constantly exceeding the rate of inflation. Additionally, it does not question the suggestion that price increase is grounds for interest (Ayub 2009). These hypotheses do not respond to the question why interest should be the market controller for the provision and demand for money. The reason why interest is given for one’s deferring of the enjoyment of current commodities should be addressed. It should also be substantiated why interest should be paid for refraining from flagging one’s present investments, which would otherwise be shrunk by the negative effects of time and expenditure.