Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law.
Islamic banking is banking or banking activity that is consistent with the principles of sharia (Islamic law) and its practical application through the development of Islamic economics. As such, a more correct term for Islamic banking is sharia compliant finance.
Sharia prohibits acceptance of specific interest or fees for loans of money (known as riba, or usury), whether the payment is fixed or floating. Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haraam (“sinful and prohibited”).
Although these prohibitions have been applied historically in varying degrees in Muslim countries/communities to prevent un-Islamic practices, only in the late 20th century were a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
Sharia compliant financial institutions represented approximately 1% of total world assets. By 2009, there were over 300 banks and 250 mutual funds around the world complying with Islamic principles and as of 2014 total assets of around $2 trillion were sharia-compliant.
According to Ernst & Young, although Islamic Banking still makes up only a fraction of the banking assets of Muslims, it has been growing faster than banking assets as a whole, growing at an annual rate of 17.6% between 2009 and 2013, and is projected to grow by an average of 19.7% a year to 2018.
Latest on this issue in India:
The Reserve Bank of India (RBI) has almost paved the way for Sharia-compliant, interest-free or Islamic banking in the country.
The measure, if implemented, is expected to give a boost to the economy and increase “financial inclusion”.
The total Islamic financial assets were estimated at around $2 trillion in 2015, practically a 10-fold increase from a decade ago and outperforming the growth of “conventional finances” in many countries.
An RBI committee on “Medium-Term Path for Financial Inclusion”, headed by Deepak Mohanty, has recommended “interest free windows” in existing conventional banks.
“Commercial banks may be enabled to open specialised interest-free windows with simple products like demand deposits, agency and participation certificates on the liability side and cost-plus financing and deferred payment, deferred delivery contracts on the asset side,” the committee has recommended.
The committee has also recommended that “in the event that interest-free banking is allowed in India, the extant regulatory guidelines in respect of capital and liquidity as applicable in the case of commercial banks would have to be made applicable to those as well”.
The government, on the other hand, also appears to be keen on implementing the Islamic banking.
The government had advised the RBI that before taking a decision, the legal/technical/regulatory issues need to be clarified by the RBI.
Following this, an inter-departmental group on Alternative/Islamic Banking was set up within the RBI to examine the issues for introducing Islamic banking.
The group has already submitted its report. The central concept in interest-free banking and finance is justice, which is achieved mainly through the sharing of risk.
Stakeholders are supposed to share profits and losses and charging of interest is prohibited.
This type of banking has four important features — Riba, Haram/Halal, Ghararar/Maysir and Zakat.
Riba is the most important aspect of interest-free banking, and means prohibition of interest. Haram/Halal is a strict code of “ethical investments” for interest-free financial activities. Such investment gives priority to the production of essential goods which satisfy the needs of the population such as food, clothing, shelter, health and education.
Under Ghrarar/Maysir, gambling in all forms is prohibited. Zakat is an instrument for the redistribution of wealth in the form of a compulsory levy.
Another feature condemned under interest-free banking is economic transactions involving elements of speculation.