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The Bank makes profits in three different ways.

Firstly, is buying and selling; meaning it buy an asset and sell at a profit. Note that, Islamic Banks are the only institutions authorized to engage in trade.

Secondly, is through leasing. Under the leasing arrangement, the Bank can for instance, finance a factory’s need for equipment and machineries and then lease out same on rental basis.

Thirdly, is through partnership. Here, it can go into partnership with either an individual or corporate body on a joint venture which is based on a pre-agreed profit and loss sharing formula. Under this arrangement, both parties can jointly contribute capital to a business and then share profit or loss based on agreed ratios.

Islamic Banking is basically a banking system that is based on the principles of profit and loss sharing, and, significantly, the prohibition of the collection and payment of interest. In that sense, it is a true partnership between the bank and its clients where risks shared according to mutually agreed ratios. For example, instead of providing a facility to finance import, an Islamic Bank will simply buy the product and sell to the importer at a mark-up. It can also go into partnership with a Real Estate developer, build houses, Industrial Estates, etc, and share in the profit according to an agreed proportion.

The rules regarding Islamic finance are quite simple and can be summed up as follows:

Main principles providing the framework for Islamic financial services are:

  • Risk-Sharing:The provider of financial funds and the entrepreneur share business risk in return for shares of profits and losses;
  • Materiality:a financial transaction needs to have a “material finality”, that is a direct or indirect link to a real economic transaction;
  • Justice:a financial transaction should not lead to the exploitation of any party to the transaction;
  • Focus on socially responsible investments/financing and avoidance of unethical activities. As such it does not deliberately finance anything that is harmful to the society.
  • Prohibition ofpre-determined rates of interest rate irrespective of the outcome of the activity financed. The main implication of this prohibition is removal of debt-based financing from the economy;
  • Prohibition of Gharar (uncertainty, or speculation):No speculation with people’s money. Therefore financial derivatives like collaterised debt obligations and some forms of Swaps are not permissible.

Banks can profit from the buying and selling of approved goods and services. The principal means of Islamic finance are based on trading, and it is essential that risk be involved in any trading activity, so banks and financial institutions will trade in sharia-compliant investments with the money deposited by customers, sharing the risks, and the profits between them.

Islamic banks are structured so that they retain a clearly differentiated status between shareholders’ capital and clients’ deposits in order to make sure profits are shared correctly.

Although they cannot charge interest, the banks can profit from helping customers to purchase a property using a ijara or murabaha scheme. With an ijara scheme the bank makes money by charging the customer rent; with a murabaha scheme, a price is agreed at the outset which is more than the market value. This profit is deemed to be a reward for the risk that is assumed by the bank.

Under the interest-based system deposits are taken as loan from customers to the bank & a fixed return is guaranteed to depositors regardless of the performance of the institution. Islamic bank receives deposits to invest them on behalf of depositors & shareholders and the profit is shared between depositors & shareholders.

Conventional banks give loans at a fixed rate without any risk on their part while under Islamic banking system, the bank shares the profits & losses from investment and bears the risk of investment.

There is some common ground. Some of the tenets of Islamic banking will appeal to anyone, Muslim or otherwise, who agrees with the underlying principles of equitable distribution for everyone, the ideals of fair trading, spending of wealth judiciously, and well-being of the community as a whole. These principles result in an exacting ethical standards relating to investment.

Conventional banks give loans at a fixed rate without any risk on their part while under Islamic banking system, the bank shares the profits & losses from investment and bears the risk of investment.

There are several Islamic instruments:

Wadiah (Safekeeping) – InWadiah, a bank is deemed as a keeper and trustee of funds. This is similar to the normal savings account. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank’s discretion, may be rewarded with a ‘hibah’ (gift) as a form of appreciation for the use of funds by the bank.

Murabaha (Cost-plus financing), a profit and loss-sharing system. This is a contract which involves purchase of goods by a bank, which sells them to its client at an agreed mark-up. Repayment is usually in installments.

Musharaka (Joint Venture/Equity financing), a profit-sharing joint venture. Here, a bank joins another entity to set up a joint venture, both parties participating in various aspects of the project in varying degrees. Profits and losses are shared in a pre-arranged fashion.

Mudaraba (Trust financing), a profit-sharing agreement. The bank contributes the finance, while the client provides the expertise, management and labour. Profits are shared in a pre-arranged manner. However, when a loss occurs, it is completely borne by the bank.

Istisna: supplying industrial products to client’s orders. This is a contract for the acquisition of manufactured goods, by specification or order, where the price is paid gradually in accordance with the progress of the job. The technique can be used for real estate development.

Wakalah (Agency). This occurs when a person appoints a representative to undertake transactions on his/their behalf, similar to a power of attorney.

Ijara (Lease/Hire purchase), which is a globally recognized mode of leasing. Here, the bank buys an item for the client and leases/hires it to him at an agreed amount and period. At the end, the client automatically becomes the owner.

Sukuk or Muqarada(Islamicbonds/ financial certificates). These are Islamic Bonds floated to finance a specific project. Investors take a share of the profits of the project being financed but also share in the risk of unexpectedly low profits or even losses. They have no say in the management of the project.

Instruments have been developed to serve part of the investment industry that were previously off limits to the Islamic investor, such as the international bond markets, in which sukuks are fast becoming a visible feature. These certificates bear a resemblance to conventional bonds, but unlike their western counterparts, they are backed by tangible assets.

Interest-free banks world-wide also offer other fee-based retail services including:

  • Checking accounts
  • Spot foreign exchange transactions
  • Funds transfer services
  • Letters of Credit
  • Bills for collection services
  • Letters of guarantee
  • Securities safekeeping investment management services
  • Financial Advisory services
  • Other traditional banking services to the extent Shari’ah rules and regulations may permit.

These services are not limited to commercial banking and extend into capital markets, insurance and other channels of non-bank financial intermediation.

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