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What is Islamic Banking

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While Islamic banks respond to the needs of Muslim customers, they are not acting as religious institutions. Like other banks they are profit-maximizing entities. They act as intermediaries between savers and investors and offer custodial and other services found in traditional banking systems. The constraints facing Islamic banks are, however, different. They are based on prescriptions in Shariah law, which encompasses a set of duties that also apply to commercial transactions, and the hadith—the authentic traditions.

 Islamic law 4 affects how the banking system functions. Four factors in particular are unique to Islamic banking. We summarize them here briefly (for a good exposition, see El-Gamal (2006).

 Prohibition of interest (Riba).

Riba is the major difference between Islamic and traditional banking. Islam prohibits all forms of riba (interest paid on loans) on the grounds that interest rates are a form of exploitation, inconsistent with the notion of fairness.

Practically, this implies that Shariah law does not allow fixing in advance a positive return on a loan as a reward for waiting. The argument is that riba implies an improper appropriation of other people’s property and is bad for growth. Islam does recognize the importance of the time value of money, but the time value is not realized as part of a loan contract; it can be realized only as part of a real transaction. For example, in a leasing agreement, the time value of money is an integral part of the rent to which the parties agree, with longer leases expected to yield higher returns.

 Prohibition of maysir (games of chance) and of gharar (chance).

 Islamic banking bans speculation, which is increasing one’s wealth by chance rather than productive effort. In practice, though, the distinction between speculation and productive effort is often blurred. While entrepreneurship itself could be interpreted as a form of gambling, maysir refers to unnecessary uncertainties not part of everyday life, such as going to a casino. Unavoidable risk is permitted. A related concept is the prohibition of gharar contracts. It applies to doubtful or uncertain contracts, such as undertaking a business venture without sufficient information or taking excessive risk. It is similar to asymmetric information; the objective is to minimize possibilities of misunderstanding and conflicts between contracting parties.

Prohibition of haram (illegal) activities.

The code of conduct for Islamic banks allows them to finance only halal (legal) activities. They are not supposed to lend to companies or individuals involved in activities deemed to have a negative impact on society (for example, gambling) or that are illegal under Islamic law (for example, financing construction of a plant to make alcoholic beverages).

 Payment of part of bank profits to benefit society (zakat).

Muslims believe that justice and equality in opportunity (not outcome) are crucial for a society to function. One mechanism to achieve this goal is to redistribute income to provide a minimum standard of living for the poor. This form of giving, zakat, is also one of the five tenets of Islam. It is generally agreed that the amount of zakat is 2.5 percent of assets held. In countries where zakat is not collected by the state, Islamic banks establish a zakat fund for collecting money to be donated to religious institutions. 2 As companies become increasingly complex, it is more and more difficult to find pure halal investments. Islamic scholars have found a way around this. Typically, when a small share of a company’s business deals with haram activities, that part of the dividend that is deemed ―tainted‖ should be donated to charity. So if 5 percent of the business of a company is deemed to be in activities not compatible with the Shariah, 5 percent of the dividend received should be given to charity. 5 Given these characteristics, would Islamic banking be good for growth? The analysis by Bhalla (2002) revealed that in comparison to the worldwide mean, Islamic countries are poor and not highly developed. Some scholars argue that Islam, by preaching fatalism, might negatively affect growth (Kuran, 1997). However, much of the evidence does not support this argument. First, the Golden Age of Islam between the 9th and 15th centuries, when advances were made in science, literature, navigation, law, and philosophy, illustrates that Islamic societies are capable of progress and innovation when the right environment is in place (Turner, 1997). More recently, Noland (2003), in an authoritative study, concludes that:

Predominantly Muslim countries are seldom outliers (either positively or negatively) in the cross-country regressions. In most cases, the coefficient on the Muslim population share is statistically insignificant. With one exception, where it is significant, it is always positive. The only case of a statistically significant negative coefficient is in the sub-national regression for Malaysia. Islam does not appear to be a drag on growth or an anchor on development as alleged. If anything, the opposite appears to be true. If one is concerned about economic performance in predominantly Muslim regions or countries, conventional economic analysis may yield greater insight than the sociology of religion.


In fact, not only does Islam not negatively impact growth, but Islamic banking could complement conventional banks and thereby help diversify systemic risk. In conventional banks, when a bank gives out a loan, the borrower bears all risks, except in the case of bankruptcy. In Islamic banking, both bank and entrepreneur share the rewards and failure. In many developing countries risk sharing might allow entrepreneurs with little savings to undertake projects they could not contemplate in an environment where all the risk lies on them. In conventional banking, the creditworthiness of the borrower is the main determinant of the lending decision, and banks are interested in the interest and principal on the loan. In Islamic banking, because profits and losses are shared, banks will receive a return only if a project is successful. Therefore, Islamic banks are more prone to finance sound projects, even if the entrepreneur has no credit history.

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