Islamic Banking

How an Islamic bank work, differences and similarities with conventional banking and major modes of finance

Financial inter-mediation is considered as a basic necessity for every human society in the past and today . History books have always noted the persistent determination of ancient communities for adopting specific arrangement which satisfy their financial inter-mediation requirements Creation of money (which liberated production resources and safeguarded means of saving methods) has caused division between individuals , namely the surplus category , which owns financial resources over their immediate needs. The deficit category which require financial resources more than they actually have. Human societies have recognized the need for adopting certain arrangements that will enable the transfer of the surplus to the category of deficit which will virtually entail more economical growth and development as well as high standards of welfare and prosperity for all people.

    By the birth of the specialization era and division of work, many  profitable activities have changed into institution with specific functions. The same thing can be said about the financial inter-mediation that had been practiced within the framework of social relationship, when monks working at their monasteries, Pharaoh, tribal sheikhs and senior traders etc, undertook the role of financial inter-mediation.

    However, things had evolved to specialized institutions conducting financial inter-mediation, namely the banks. Traditional banks had therefore been set up to offer financial inter-mediation through loan (from surplus category) and lending (to deficit category). Conditional profit in loans evolved in order to cover the expenses and achieve profits to depositors. Banks in the beginning were maintaining deposits free of charge.

    When fierce competition surfaced between banks, they were unable to attract savings without stipulating terms of profits to the depositors. Therefore, traditional bank became a loan seeking and lending institution whose underlying source of income is the difference between positive and negative interest. But, was it possible for the depositors to give loans directly to the investors without the services of the bank?

    Contemporary analysis look at the bank as specialized information institution. Securing of true information, follow up and collection of data are indeed a highly expensive processes, yet such banks apart from individual are enjoying the characteristic of economies of large scale which enables such banks to pursue the above processes in a relatively low expenses.

     Therefore the conventional work of the bank had been based on isolation of depositors (surplus category) from investors and those seeking finance for their projects (deficit category), as depositors normally do not give attention to the risks of end lenders, as they only take the risk of depositing their monies at the bank, if there is any.

   However, the bank takes the risk of end lenders whom it had separated from sources of money. Though, if the lender fails to cover payment of its debts, then the risk will be borne by the bank itself and in normal cases should be indemnified from its profit or capital. However, observers to development of banks in recent days, see clear debility of the role of commercial banks which are based on the concepts of loan giving and lending in sophisticated economies, mainly because improvements relating to maintaining the information and methods of surveillance have led creditors to lean directly towards contacting the investors. Money markets have therefore played an increasing role in financial inter-mediation because they give the creditors the opportunity of bearing direct risks on behalf of the users of money, while the function of banking institution is management on behalf of others, maintaining service charge and arrangement of deals … etc, are seen by many observers as a trend which will prevail for long time over the contemporary financial development and will lead, as time passes to a further deterioration in the traditional role of the commercial bank (i.e. isolation of risks).

    We would see for example, that the revenues acquired by banks such as service charge are increasingly growing in relation to revenue from profit. For the purpose of illustration, the share of commercial banks decreased in the last twenty years in the total U.S financial assets from 40% to 25%, because they were directed towards management of monies instead of lending. As a result of this different mode, securitisition were widely spread, giving the depositors the chance of bearing the responsibility of direct risk of money.

    Islamic bank is best known for its financial inter-mediation function which operates without interest. Since about one century ago, Muslims had reached the conclusion that the interest given by banks is the core of forbidden usury, because the increase in the loan which is the fundamental function of traditional banks is considered as part of usury and for this reasons banks were not widely known between Muslims except during colonial periods – despite its long rooted practice by the Europeans, since many hundreds years go. Muslims had therefore strived, after maintaining independence by their respective countries to establish banking systems that will be harmoniously coherent with the rules of Shari'ah (Islamic law).

  They realized that financial inter-mediation is deemed to have been a basic function in the life of human societies and that Muslims, had adopted long time ago certain arrangement which would fulfill the need of financial inter-mediation. Transfer of money from the surplus category (i.e. the number of individuals and institutions that owned financial resources surpassing their immediate demand) to the deficit category (i.e. those who require financial resources over-exceeding what they now acquired) were conducted in the past in accordance with the Mudaraba mode.