Islamic finance is a system activities consistent with Shariah based on Islamic principles which at the core refuses collecting interest, transactions involving uncertainty and speculation. Furthermore, it is based on Islamic economic system and it is not restricted to Muslims only.
Furthermore, Islam as a religion clearly prohibits the Ribah (interest) hence the basic principal of Islamic banking is the prohibition of Ribah base transactions. To not forget, it is also written in the Holly Quran about prohibition of Riba. The following verses will be able to taken as examples.
"Those who devour Riba will not stand (especially for judgement before Allah) except as stands one whom Satan by his touch has driven to madness. That is because they argue: "Business and Riba similar to each other."But Allah has made "business" Halal and He is made 'Riba' Haram. Those who after receiving this warning (concerning the Haram of Riba) from their Lord,(now) desist (from Riba) , may keep whatever they had previously earned (as Riba) ; and their case (will now be judged by) Allah (alone ,i.e. the Islamic State will not deal with that matter); but those who return (to Riba even after this revelation of the Quran ) are companion of fire (of Hell) ; they abide therein (forever)."
Holy Quran -Surah 02- Al Baqarah verse 275
Ribah (Interest)
''Riba (interest, usury) is primarily an economic issue in view of the fact that all religions and mythologies have prohibited, restricted, discouraged, disliked, or degraded Riba in one way or the other since the inception of human interaction. All three major revealed (Ilhami) religions i.e., Islam, Christianity, and Judaism have strongly condemned and prohibited Riba in its original versions. Later, the clerics of Jews and Christian Church abandoned the prohibition of Riba (interest, usury) that led the mankind into the economic anarchy of the present era.
Islam - the most modern revealed religion is still upholding the righteous prohibition of Riba (Interest) although not in practice in any of the Islamic country at governmental level but there is immense enthusiasm for Riba-Free financial system in Muslims. The western economists have discussed the issue at large in the twentieth century and many of them are also of the view that the religious prohibition should be brought back into the conscious of the people.
As long as Reba(Interest) prohibition was enforced with religious zeal, people were prosperous and the wealth distribution was not abnormal as it is today, and obviously there was not much debate on the subject but since the Riba(Interest) was made legal by Judo-Christian amendments in the divine law - its destructive fallouts earthed at large. The debate started on Riba(Interest) for its literal interpretation to economic implications.
It is very unfortunate to observe that, in this debate, some misconception in Muslims led to a widely circulated explanation of Riba(Interest)that divide Riba(Interest) in to two types, one from Quran (riba-al-nasiah) and the other from Sunnah (riba-al-fadlor riba-al-buyu) and interpreted these as "riba (Interest)in debt" and "riba(Interest) in trade" respectively, this division which actually is not the case; is a direct conflict with basic faith of Islam (please see "Present Islamic understanding and misconception about Riba(Interest)" for details). No clear concept and universal definition of Riba exists, different views and explanations have created much confusion in Muslims in the understanding of Riba (Interest). Unless, it is not found that Why Riba was declared Haram (prohibited), the definition of Riba (Interest) is not possible.''07/03/2012 Hazaribah.com
The literal meaning of (Ribah) interest as it is used in the Arabic language means to excess or increase. In the Islamic terminology interest means effortless profit or that profit which comes free from compensation or that extra earning obtained that is free of exchange. Hazrat Shah Waliullah Dehlvi a great scholar and leader have given a very concise and precise definition of interest. He says,
"Riba` (interest) is a loan with the condition that the borrower will return to the lender more than also better than the quantity borrowed.
Almighty Allah states in Quran:
يَا أَيّÙهَا الَّذÙينَ آمَنÙواْ لاَ تَأْكÙÙ„Ùواْ الرّÙبَا أَضْعَاÙًا مّÙضَاعَÙَةً وَاتَّقÙواْ اللّهَ لَعَلَّكÙمْ تÙÙْلÙØÙونَ
3:130 O you who have believed, do not consume usury, doubled and multiplied, but fear Allah that you may be successful.
ÙˆÙŽØ£ÙŽØَلَّ اللّه٠الْبَيْعَ ÙˆÙŽØَرَّمَ الرّÙبَا
2:175 Allah has permitted trade and has forbidden interest
Quran explicitly prohibits Riba (interest) and since Quran is an undisputed source of guidance, all Muslims unanimously agrees on prohibition of Riba(interest). There is no difference of opinion among any school of thought on prohibition of Riba (interest) in Islamic Shariah.
Difference between Islamic banking and conventional
One must refrain from making a direct comparison between Islamic banking and conventional banking (apple to apple comparison). This is because they are extremely different in many ways. The key difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations with as of the conventional
The foundation of Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the Shariah in all of its actions and deeds. The original meaning of the Arabic word Shariah is 'the way to the source of life' and is now used to refer to legal system in keeping with the code of behaviour called for by the Holly Qur'an (Koran). Amongst the governing principles of an Islamic bank are:
The absence of interest-based Riba (interest) transactions;
The avoidance of economic activities involving oppression (zulm)
The avoidance of economic activities involving speculation (gharar);
The discouragement of the production of goods and services which contradict the Islamic value (haram)
In another word, conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.
Islamic law considers a loan to be given or taken, free of charge, to meet any contingency. Thus in Islamic Banking, the creditor should not take advantage of the borrower When money is lent out on the basis of interest, more often that it leads to some kind of injustice. The first Islamic principle underlying for such kind of transactions is "deal not unjustly, and ye shall not be dealt with unjustly" [2:279] which explain why commercial banking in an Islamic framework is not based on the debtor-creditor relationship.
The other principle pertaining to financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labour and capital. As no payment is allowed for labour, unless it is applied to work, there is no reward for capital unless it is exposed to business risk.
Thus, financial intermediation in an Islamic framework has been developed on the basis of the above-mentioned principles. Consequently financial relationships in Islam have been participatory in nature.
Lastly, for the interest of the readers, the unique features of the conventional banking and Islamic banking are shown in terms of a box diagram as shown below:-
Conventional banking
Islamic banking
1. The functions and operating modes of conventional banks are based on fully manmade principles.
1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah
2. The investor is assured of a predetermined rate of interest.
2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
3. It aims at maximizing profit without any restriction.
3. It also aims at maximizing profit but subject to Shariah restrictions.
4. It does not deal with Zakat.
4. In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a ZakatCollection Centre and they also pay out their Zakat.
5. Lending money and getting it back with compounding interest is the fundamental function of the conventional banks
5. Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customer's business very well.
6. It can charge additional money (penalty and compounded interest) in case of defaulters.
6. The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are given for early settlement at the Bank's discretion.
7. Very often it results in the bank's own interest becoming prominent. It makes no effort to ensure growth with equity
7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.
8. For interest-based commercial banks, borrowing from the money market is relatively easier.
8. For the Islamic banks, it must be based on a Shariah approved underlying transaction.
12. A conventional bank has to guarantee all its deposits.
12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position.
The main concept of sharia
According to the dictionary.com sharia mean 'Islamic canonical law based on the teachings of the Koran and the traditions of the Prophet (Hadith and Sunna), prescribing both religious and secular duties and sometimes retributive penalties for lawbreaking. It has generally been supplemented by legislation adapted to the conditions of the day, though the manner in which it should be applied in modern states is a subject of dispute between Islamic fundamentalists and modernists.''
There are two sources of Sharia (understood as the divine law): the Qur'an and Sunnah. According to Muslims, the Qur'an is the unalterable word of God. Much of the Qur'an exhorts Muslims to general moral values; only 80 verses of the Qur'an contain legal prescriptions. The Sunnah is the life and example of the Islamic prophet Muhammad. The Sunnah's importance as a source of Sharia, is confirmed by several verses of the Qur'an (e.g. [Quran 33:21]). The Sunnah is primarily contained in the hadith or reports of Muhammad's sayings, his actions, his tacit approval of actions and his demeanor. While there is only one Qur'an, there are many compilations of hadith, with the most authentic ones forming during the sahih period (850 to 915 CE). The six acclaimed Sunni collections were compiled by (in order of decreasing importance) Muhammad al-Bukhari, Muslim ibn al-Hajjaj, Abu Dawood, Tirmidhi, Al-Nasa'i, Ibn Majah. The collections by al-Bukhari and Muslim, regarded the most authentic, contain about 7,000 and 12,000 hadiths respectively (although the majority of entries are repetitions). The hadiths have been evaluated on authenticity, usually by determining the reliability of the narrators that transmitted them. For Shi'ites, the Sunnah may also include anecdotes The Twelve Imams.
The process of interpreting the two primary sources of Islamic law is called fiqh (literally meaning "intelligence") or Islamic jurisprudence. While the above two sources are regarded as infallible, the fiqh standards may change in different contexts. Fiqh covers all aspects of law, including religious, civil, political, constitutional and procedural law. Fiqh depends on 4 sources:
Interpretations of the Qur'an
Interpretations of the Sunnah
Ijma, consensus amongst scholars ("collective reasoning")
Qiyas/Ijtihad analogical deduction ("individual reasoning")
Amongst the sources unique to fiqh, i.e. ijma and qiyas/ijtihad, the former is preferred. In Shi'a jurisprudence the fourth source may be expanded to include formal logic (mantiq). Historically the fiqh also came to include comparative law, local customs (urf) and laws motivated by public interest, so long as they were allowed by the above four sources. Because of the involvement of human interpretation, the fiqh is considered fallible, and thus not a part of Sharia (although scholars categorize it as Islamic law).
There exist five schools of thought of fiqh, all founded within the first four centuries of Islam. Four are Sunni Hanafi, Maliki, Shafi'i and Hanbali and one Shia: Ja'afri (followed by most Shia Muslims) Many Islamic scholars today advocate renewed approaches to fiqh that don't necessarily follow the traditional five allegiances. The Salafi movement attracts followers from various schools of fiqh, and is based on the Quran, Sunnah and the actions and sayings of the first three generations of Muslims.
(Sources of Islamic law)
