Islamic banking: conceptual fundamentals and basic features
Islamic banking is a phenomenon of the finance and banking world in the recent decades. Rejecting interest policy as an instrument for any business activity, Islamic banking is based on the substitutions for interest that are profit, rental, commission, and wage, all of which are regarded as legitim...
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irk-123456789-239962022-09-29T21:29:58Z Islamic banking: conceptual fundamentals and basic features Ozsoy, Ismail Finance Islamic banking is a phenomenon of the finance and banking world in the recent decades. Rejecting interest policy as an instrument for any business activity, Islamic banking is based on the substitutions for interest that are profit, rental, commission, and wage, all of which are regarded as legitimate earnings of trade, its derivatives, joint venture and partnerships, leasing, and other lawful and real economic activities. Before explaining the interest free finance and banking methods, this paper first criticizes the interest policy, tries to uncover its nature, and its prohibition reason by the Quran. Then, it makes brief ‘interest-rental’ and ‘interestprofit’ comparisons. The paper also deals with the foundations and some basic characteristics of Islamic banking together with its practical appearances in the world. Key words: interest/usury, Islamic/interest-free banking. Мусульманська банківська справа — явище, що набуло поширення у фінансовому та банківському світі в останні десятиліття. Відкидаючи вигідний поліс, як інструмент для будь-якої ділової активності, Мусульманська банківська справа заснована на замінах для інтересу у вигляді доходу, рентного доходу, комісії, заробітної плати, що розцінюються як законна виручка від торгівлі, спільних підприємств і товариств, оренди та іншої законної і реальної господарської діяльності. Автор статті критикує вигідний поліс, намагається розкрити його природу та причину заборони кораном. Ключові слова: інтерес/лихварство, Мусульманське/безвідсоткове банківське діло. Мусульманское банковское дело — явление, получившее распространение в финансовом и банковском мире в недавние десятилетия. Отвергая выгодный полис как инструмент для любой деловой активности, Мусульманское банковское дело основано на заменах для интереса в виде дохода, рентного дохода, комиссии, и заработной платы, которые расцениваются как законная выручка от торговли, совместных предприятий и товариществ, аренды и другой законной и реальной хозяйственной деятельности. Автор статьи критикует выгодный полис, пробует вскрыть его природу, и причину запрещения кораном. Ключевые слова: интерес/ростовщичество, Мусульманское/беспроцентное банковское дело. 2010 Article Islamic banking: conceptual fundamentals and basic features / Ismail Ozsoy // Економічний вісник Донбасу. — 2010. — № 4(22). — С. 140-148. — Бібліогр.: 25 назв. — англ. 1817-3772 http://dspace.nbuv.gov.ua/handle/123456789/23996 336.71:297 en Економічний вісник Донбасу Інститут економіки промисловості НАН України |
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Finance Finance Ozsoy, Ismail Islamic banking: conceptual fundamentals and basic features Економічний вісник Донбасу |
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Islamic banking is a phenomenon of the finance and banking world in the recent decades. Rejecting interest policy as an instrument for any business activity, Islamic banking is based on the substitutions for interest that are profit, rental, commission, and wage, all of which are regarded as legitimate earnings of trade, its derivatives, joint venture and partnerships, leasing, and other lawful and real economic activities. Before explaining the interest free finance and banking methods, this paper first criticizes the interest policy, tries to uncover its nature, and its prohibition reason by the Quran. Then, it makes brief ‘interest-rental’ and ‘interestprofit’ comparisons. The paper also deals with the foundations and some basic characteristics of Islamic banking together with its practical appearances in the world. Key words: interest/usury, Islamic/interest-free banking. |
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Article |
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Ozsoy, Ismail |
| author_facet |
Ozsoy, Ismail |
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Ozsoy, Ismail |
| title |
Islamic banking: conceptual fundamentals and basic features |
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Islamic banking: conceptual fundamentals and basic features |
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Islamic banking: conceptual fundamentals and basic features |
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Islamic banking: conceptual fundamentals and basic features |
| title_full_unstemmed |
Islamic banking: conceptual fundamentals and basic features |
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islamic banking: conceptual fundamentals and basic features |
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Інститут економіки промисловості НАН України |
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2010 |
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| citation_txt |
Islamic banking: conceptual fundamentals and basic features / Ismail Ozsoy // Економічний вісник Донбасу. — 2010. — № 4(22). — С. 140-148. — Бібліогр.: 25 назв. — англ. |
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Економічний вісник Донбасу |
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140
Економічний вісник Донбасу № 4 (22), 2010
Ismail Ozsoy
Introduction
According to Islam, the income kinds of profit and/
or rental-fee are permissible while the interest income is
prohibited.1 From the Islamic perspective, interest (or
usury) is an actual or potential excess or surplus without
any comparable equivalent in loans or exchanges. This
excess or surplus has not any consideration that can be
matched with so that it can be regarded as legitimate and
rightful earnings. Thus it causes a financial loss to either
of two parties.2
Interest is of two kinds. First, interest of loan (riba
al-dain in Arabic), one that appears in loans as a percentage
or any fixed payment added to the principle, is the most
widespread, and the most debated, kind of interest known
by all. Lending money, say €100, at a certain interest
rate, say 5%, is the example. Second is interest of
exchange (riba al-bai’ in Arabic), one that appears in
exchanges.
The second one -interest of exchange- is also divided
into two kinds; one is called interest of surplus (riba al-
fadl in Arabic) that appears as a quantitative surplus in
one of the exchanged goods of the same kind -as in the
case when two measures of corn is exchanged for three
measures of corn, even if it is due to the difference of
quality. And the other is called interest of delay or deferral
(riba al-nasia in Arabic) that appears in exchanges as a
quantitative or potential surplus (value differentiation)
when the delivery of one of the goods exchanged is
delayed, as in the case when a ton of iron is sold for the
same amount of iron on a deferral basis; let alone for a
larger amount of delayed iron.
Here, interest arises as a potential value
differentiation between two goods -iron for iron- due to
the delayed delivery of one of the goods. Time, or term,
is a primary reason for the “value differentiation” between
the present and future goods exchanged; hence, it causes
a potential excess in one of the goods when compared to
the other good. Due to the fact that nobody knows in
advance for whom and how much this potential surplus
proves to be realized, Islam prohibited all the delayed
sales or futures.
The exception of the interest of delay is the exchange
wherein only one of the items is ‘money’ since any
delayed ‘money-for-commodity’ or ‘commodity-for-
money’ exchanges do not establish any interest
relationship. This is because of the value measuring
character of money for commodities, and the need of
the people not having cash for pressing demands.
All the futures in the form of forward rate
agreements, and exchanges of financial derivatives for
each other without corresponding to any real value change
in the underlying real assets on which derivative are based,
also include interest. For example selling cash €100 for
delayed $130 includes interest of delay.
Similarly, exchange of loan-for-loan with different
quantities or with different interest rates gives way to
interest as with the derivatives so widespread in the
developed countries, in US particularly. The exception to
this is swap wherein two loans of the same quantity and
of the same term are traded.
Shortly putting, interest is a measurable or noticeable
imbalance or disproportionate in exchanges or loans for
one party to the loss of the other. With its this nature,
interest causes economic disparities between individuals,
factors of production and even nations, resulting in
considerable social and economic problems. These
imbalances appear as bubbles and crises eventually in
the financial markets when they can not be sustained.
Though not expressed so far so clearly, interest based
transactions are the most effectual reasons of the
economic bubbles and their consequences in the form of
crises.3 This is a reason for interest to be banned by all
the religions and for its being criticized by most of the
philosophers and scholars throughout history.
Interest Theories
The issue of interest has been controversial
throughout history. It was banned by the Abrahamic
religions Judaism, Christianity and Islam, as well as by
all other religions, and criticized by philosophers of the
Ancient Times and the Middle Ages. The expansion of
commerce and trade to the end of the Middle Ages in
Europe required frequent capital borrowing. Due to the
need of large sums of capital borrowing, many theories
of interest arose to confirm the necessity for interest and
УДК 336.71:297
Ismail Ozsoy,
PhD (Economics), Prof., Fatih University, Istanbul, Turkiye
ISLAMIC BANKING:
CONCEPTUAL FUNDAMENTALS AND BASIC FEATURES
1 Here, the terms ‘interest’ and ‘usury’ (in Arabic ‘riba’) are definitely interchangeable.
2 See, Ozsoy, Ismail, “Faiz”, Islam Ansiklopedisi (Islamic Encyclopedia), Tü rkiye Diyanet Vakf?, 1995, XII-110-26.
3 http://en.wikipedia.org/wiki/Economic_bubble, accessed on Nov 27, 2008.
141
Економічний вісник Донбасу № 4 (22), 2010
Ismail Ozsoy
to justify it despite the robust resistance of the Church
initially that lasts 1500 years but being tolerant afterwards
due to some reasons. Thus, the banking system of the
modern times has completely been based on the interest.
However, these theories have failed to explain why
interest is paid. This situation has always produced
suspicions about the necessity for, and the legitimacy of,
interest. To us, all opinions defending interest seem to
continue to be inconsistent and incongruous because of
the nature of the interest that we will explain below.
The common point of nearly all theories of interest
is productivity of capital. Besides, there is “time-preference
theory” of Bohm-Bawerk, which states that there is a
difference of value between present goods and future
goods. In his view, the former are worth more than the
latter. The difference between the two must be equalized
through interest payment for present goods -namely ready
money- to be lent for a certain period. These two points
are seemingly the strongest sides of the theories of interest.
Based on mainly these two interest theories,
capitalism imagines that potential income of capital -in
ready money- is transformed to an actual yield as soon
as it is loaned. As for the value differentiation; capitalism
requires the debtor to pay a fixed interest to the creditor
at the very beginning of lending, deciding that this
differentiation will always be against the debtor although
it might appear for either side, for the creditor against
the debtor, or for the debtor against the creditor.
As for Islam, it does not accept to charge interest
at the beginning, realistically taking into consideration
dynamism and variability of economic conditions.
Because it is impossible to know at the beginning whether
or not the potential income in capital will realize actually,
and to estimate how much it will be even if it does.
Quranic Approach to Interest
Then, the most important reason for interest to be
forbidden by Islam and the only reason the Quran
particularly mentions thereabout can be stated as
following:
“Interest is prohibited due to the fact that either the
borrower or the lender would absolutely and inevitably be
subjected to an injustice in any case, for its rate is fixed at
the very beginning, although it is impossible to predict the
outcome, profit or loss, or how much either would be.”
“If you persist in interest based transactions” says
the Quran, “Either you will wrong, or you will be
wronged.”4
Thus, it is clear that Quran identifies interest with
injustice, that is unfair and unequal distribution of income.
Any interest rate, low or high, is a reason for unjust and
unequal sharing of the outcome of the business. Because,
while high interest rates in hard economic conditions may
cause the borrower to go bankrupt, low interest rates in
good economic conditions cause the lender to undergo
an injustice.
It is never possible for mankind to find a fair interest
rate for any time and for any sector of the economy
since man can not see the future outcome of the business,
thus there will be a “deviation” —that hurts either the
borrower or the lender- between the “initially determined
interest rate” and “finally realized outcome”, whereby
causing an injustice to either borrower or the lender.
Once this very feature of interest is recognized, we
can resolutely claim that it is impossible for any religion,
philosophy, economic or political theory to agree with
interest policy if they favor the fair distribution of income.
Here we can resemble the interest mechanism to a two-
bladed saw, or a knife, that cuts on both sides, on one
occasion it is the lender who is injured and the borrower
on the other occasion, but either side is unavoidably
damaged by the interest mechanism.
So, we can say that the prohibition of interest by
Islam has its origins in the ultimate sensitivity of the Quran
to ‘right’ and its protection, with a vision of embracing
both interest payer and receiver.
The discussion throughout history of distinguishing
between interest, which is favored by many, and usury,
which is rejected by all, does not make any sense to us.
Because, while any high rate of interest damages the
borrower in hard economic conditions, any low rate
damages the lender in favorable economic conditions
where return on capital is high. That is why we can not
take interest and usury separately.
Usury is condemned throughout history to be
exorbitant and excessive and thus disapproved by almost
everybody. Yet, is not a high interest rate (so-called usury)
closer to justice in the favorable economic conditions
where return on capital is very high than a low interest
rate that is favored by many? Hence, so called a reasonable
interest rate is as much exposed to criticism as usury. It
means that it is not logical to exclude usury from interest,
or interest from usury, since both have the same effect
-the effect of injuring either of the two parties-.
Time Value of Money
As for differentiation of value, it is called today ‘time
value of money’ and used to justify the interest. Time
value of money is based on the premise that an investor
prefers to receive a payment of a fixed amount of money
today, rather than an equal amount in the future, all else
being equal.5 Thus, according to Bö hm-Bawerk, in order
4 Qur’an, Baqara, 279.
5 http://www.statemaster.com/encyclopedia/Time-value-of-money, accessed June 20, 2009.
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Економічний вісник Донбасу № 4 (22), 2010
Ismail Ozsoy
to persuade a money holder to lend €100 today for one
year time, s/he must be offered to be paid back, for
instance, €110 since €100 of today is equal in value to
€110 of one year later. Here, €10 is claimed to be one
year time value of money.
>From the Islamic perspective, money is not taken
as a commodity, to be sold and bought, in order to keep
the economy from turning to fully a primitive barter system,
one in which money is included as another commodity
together with other goods. Money is definitely distinguished
from the commodities for its being a unit of value measure
for all other goods. It is a unit of measure like measures of
weight and length. Thus, its value should not change day-
to-day like elastic materials that stretch or shrink by the
time as with other units of measure, for example, as one
meter is 100 cm as well as one kg is 1000 gr. all the time.
Its value is not measured by other things, but it always
measures all other goods, except the inflationary cases
where its value is restored by indexing it to a group of
goods. So, 100 lira should be exchanged for 100 lira today
and tomorrow if it is a unit of value to measure other
things, not a commodity to be measured by other measures.
Therefore, we had better change the term ‘time
value of money’ to the ‘time value of goods’, which are
measured by money for the sake of monetary economy.
This is because money is not any thing itself; its value is
derived from the commodities it represents, except the
case when it is a commodity-money like gold and silver.
If somebody wants to make money out of money, s/he
should not only deal with it, but correlate any monetary
transaction with a real asset, i.e. a commodity of which
value changes according to the daily supply and demand
conditions, thereby making a profit or a loss.
It should be noted here that, while the value of any
currency as a unit of measure should not change by the
time, its value changes of course compared to other
currencies. That is why exchange rates of different
currencies frequently change.
In fact, the value differentiation between the present
goods and the future goods is pointed out by the Prophet
Muhammad fifteen centuries ago who therefore prohibited
delayed sales saying,
“Sell gold for gold, silver for silver, wheat for
wheat, barley for barley, dates for dates, and salt for
salt — like for like, equal for equal, and hand-to-hand;
if the commodities differ, then you may sell as you wish,
provided that the exchange is hand-to-hand.” 6
Based on the time value of money; capitalism
requires the debtor to pay a fixed interest to the creditor,
deciding at the very beginning of lending that this value
differentiation will always be against the debtor; although
it might appear for either side, -for the creditor against
the debtor or for the debtor against the creditor-.
As regards the position of Islam that is based on
the saying of the Prophet Muhammad on the
differentiation of value, it does not agree to set a price
for ‘time’ during which a sum of money is loaned, or a
due payment is postponed to a future time, since it is not
possible to know what ‘time’ will bring for either side.
This is because a great importance is attached to the
value equality between the two items that are exchanged.
In this respect, a ready €100 can not be exchanged for a
delayed €110 for it is impossible to foresee the future
and to forecast the outcome of the business at which a
loan with a fixed interest is used. Hence, these two
amounts may not be equal in value at the maturity; it is
probable that €100 of today may turn to have the value
of €90 next year due to the revaluation of that currency;
there may be a negative time preference instead of positive
one. For instance, it might be better to have 90 m3 natural
gas for heating now in the winter than having 100 m 3 in
the coming summer. Likewise, a refrigerator, now in the
winter, may be worth less than it will be in the summer
to come. As seen, not always the present goods are more
valuable than the future ones and it is not possible to
determine the exchange rate between them.
Likewise, since it is impossible to predict for which
side (for the creditor or the debtor) the value
differentiation would appear, Islam has forbidden all
delayed sales in order to protect the financial rights of
both sides. Thus, while a ton of iron can be exchanged
today for 100 packs of cement at the market price, the
same exchange is not permitted in case one of the two
goods is delayed. Nor the two goods of the same kind
are allowed to be exchanged because of the possibility of
value differentiation in one of the two goods, even if
they are of the same amount. Thus, a ton of coal in summer
can not be exchanged for the same amount of coal to a
term in winter, let alone for an excess amount of it.
Financial Bubbles
A more important example that can be suggested to
have given way to the financial bubble after the burst of
which the 2008 Global Financial Crisis occurred is the
sale of, say, a financial certificate of $100 with 10% rate
of interest and 1 year time for a higher amount and/or
for a higher interest for two years time. Thus, a financial
6 Muslim, Abu’l-Husain b. al-Hajjaj. (1955). Al-Jami’ al-Sahih, ed. M. Fuad Abdulbaqi, 1. ed., 1374/1955 (in Arabic), Kitab al-Musaqat,
81. Similar hadiths (sayings) of Prophet Mohammad are available at http://www.usc.edu/schools/college/crcc/engagement/resources/texts/
muslim/hadith/muslim/010.smt.html [accessed on 16 November 2009] and at http://www.financeinislam.com/article/10/1/552 [accessed
on 16 November 2009].
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Економічний вісник Донбасу № 4 (22), 2010
Ismail Ozsoy
bubble is built if the nominal increase in the value of the
financial certificate is not balanced with a real value
increase in the underlying assets upon which the financial
certificates or derivatives are based.
In short, because it is not possible what ‘the time’
brings in the future, any exchange on a deferred basis is
not allowed in Islam in order to avoid any financial loss
that may arise on behalf of either side while capitalism
seems to favor only the creditor.
There is an exception to that prohibition: Islam does
allow sales in which one of the two items exchanged is
‘money’ as is the most part of the daily trade transactions.
This is so for several reasons. First, people need for
delayed sales because they may not have a ready
purchasing power -cash money- while the need for good
or service to be bought is urgent and pressing. Second,
common reliance is placed upon money as a unit of
measure of value more than on other units of measure.
Thus, while people do not consent to measure the value
of any commodity with another commodity, they agree
to do this with money due to its being a standard value
unit. Third, people are indifferent to the differentiation of
value between ‘money’ and ‘goods’ because of their being
of different kinds, and because market conditions may
cause commodity prices to change any time.
Similar to interest, Islam prohibits gambling, a zero
sum game where one party loses while the other gains,
and any trade where one of the items traded is uncertain,
that is called gharar, in order to protect both buyer and
seller. Gharar is the sale of probable items whose existence
or characteristics are not certain, due to the risky nature
that makes the trade similar to gambling.7 Specific
examples of gharar transactions are e.g., selling the birds
in the sky or the fish in the water, the catch of the diver,
an unborn calf in its mother’s womb etc.
Comparison of Interest with Rent
Say, one has a sum of money, who wants to make
money out of it. What is the difference between “the
interest income” he gets by lending his money at interest
and “the rental” he gets by leasing a house he has bought
with the same money?
The element of differentiation between interest
income and rental-fee depends on the fact that if the thing
is non-consumable and capable of being used without
changing its essence and without damaging its intactness,
the benefit received from it would be a good consideration
for the rental-fee. This benefit may be a service rendered
by persons or a usufruct8 (right to use) of things.
On the other hand, where the borrowed/rented thing
is consumable and perishes when it is used, -as in the
case of money, food, and drink-, the rental paid for the
use would be in excess of what is owing, that is the
principal, by the lessee. This excess so paid is interest,
regardless of the fact that it is called ‘rental’.9 This is
because the advantage of the rented thing -which is non-
consumable- is certain, for it is always ready to be used
in any case, and it is strongly possible for it to be handed
over by the lessee10 to the lessor.11
Comparison of Interest with Profit
As for the relationship between interest and profit;
profit is a surplus to assets, shared between capital and
entrepreneur, resulting from investing a certain amount
of money in an economic activity such as agriculture,
industry and commerce, and then it is re-transformed
whether into a larger sum (where profit is realized) or, a
lesser sum (where actual loss is suffered). Thus, profit
and loss are twins.
Profit is a result and consideration of an actual
supplement and contribution to the revenue of the
community by capital coupled with entrepreneur. When
the owner of capital participates in a business only with
his capital, he has to take risks of loss in that business to
deserve a profit. Therefore, profit can be seen as the
return for bearing risk. For, after all, business is subject
to failure; so in profit, the principle is: “nothing ventured,
nothing gained”.
One of the elements that make profit permissible is
its being a ratio of the ‘realized positive outcome’ at the
end of the business, not the ‘rate of return on the loan’
itself that is predetermined as in the case of interest. While
profit is a result of a positive result, interest has nothing
to do with the result of the business regardless it is a
positive or a negative sum game.
In profit, when the investment results in a loss, the
owner of capital is directly affected by it, whereby the
community is affected indirectly. But, interest is an income
given to money loaned, in any case, even when it does not
add any value to the assets, or revenue, of the community.
7 El Gamal, Mahmoud Amin. (2000). A Basic Guide to Contemporary Islamic Banking and Finance. Rice University. June 2000, http:
//www.witness-pioneer.org/vil/Books/MG_CIBF/chapter_1.htm, accessed on Nov. 20, 2008.
8 Usufruct is the right of using and enjoying the profits of an estate or other thing belonging to another without impairing the substance.
In other words, it is a legal right to use and enjoy the profits of any property belonging to someone else provided that the property itself
is not injured or damaged in any way.
9 Homoud, op. cit. p. 133-34
10 A person who has use of a building, an area of land, etc. on a lease.
11 A person who gives sb the use of a building, an area of land, etc. on a lease.
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Економічний вісник Донбасу № 4 (22), 2010
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In interest, when there is a loss, capital is not affected by
it, although that loss directly concerns the capital itself
and all the community is affected by it. That is to say,
interest income may be earned at the expense of all others
in the society. Interest may be ‘taking without giving’ while
profit is made only when the capital contributes to the
community and in proportion to its contribution.
Interest-free Banking: From Theory to Practice
Although Islam prohibits the option of interest in
the business life, it offers a wide variety of many other
options in a way that there is not need left to interest any
more in order to carry out all kinds of economic activities,
and interest-free banking in particular.
In Islamic economics, interest is substituted with
profit, rental, commission, and wage, all of which are
regarded as legitimate earnings of trade, its derivatives,
joint venture and partnerships, leasing, and other lawful
and real economic activities. So many kinds of sale and
equity participation with its many alternatives, which are
precisely defined in the Islamic law books, can be said to
be enough to meet the needs of the modern communities.
Moreover, there is no limit to devising and formulating
new methods provided they are cleared of interest.
Here, Islamic banking is a system of banking that is
consistent with Islamic economics that prohibits interest
as well as investing in unlawful businesses such as
alcohol, pork, pornography, and gambling, etc. Although
Islamic economics favours a genuine free market where
prices are freely determined by supply and demand, profit
maximization in Islamic banking and other economic
activities is only limited by social and moral values.
Therefore Islamic banking is multi-purpose and not purely
commercial and it is strongly equity-oriented.
Islamic banks differ from the traditional banks in
that they operate according to the principles of Islam;
they trade in commodities not in money; and there is
more to Islamic banking than maximizing the profit in
contrast to the traditional banks as it aims to contribute
towards a more equitable distribution of income and
wealth, and increased equity participation in the economy
(Chapra, l982). Apart from traditional banks and financial
institutions with their character of mostly lending, Islamic
banks are either trader, or lessor or partner in business
transactions.
Profit and loss sharing (mudaraba) and equity
participation (musharaka) are the most favored modes
of finance of Islamic banking. Mudaraba is an
arrangement between a capital provider and an
entrepreneur, whereby the entrepreneur can mobilize
funds for its business activity. The entrepreneur provides
expertise and management and is referred to as the
Mudarib. Any profit made is shared between the capital
provider and the entrepreneur according to a pre-agreed
ratio. Supply of, and demand for, capital and enterprise
are the basic determinant of this ratio besides the
bargaining power of the parties. Only capital provider
bears any capital loss if occurred while the entrepreneur
bears the loss of his labor since he has toiled for nothing.
Participatory arrangements between capital and
labor, as in the case of mudaraba, reflect the Islamic
view that it should not be only the borrower who bears
all the risks and costs of a failure in business, resulting in
a balanced distribution of income and not allowing lender
to monopolize the economy as with the most outstanding
outcome of interest mechanism.
Musharaka (joint venture or equity participation) is
a partnership contract by the mutual consent of the parties
for sharing of profits and losses in a joint business. Here,
the bank provides funds, which are mixed with the funds
of the business enterprise, and others. All providers of
capital are entitled to participate in management, but not
necessarily required to do so. The profit is distributed
among the partners in pre-agreed ratios, while the loss is
borne by each partner strictly in proportion to respective
capital contributions.
In equity participation (musharaka) or in a profit
and loss sharing (mudaraba), what makes profit
permissible is the profit-sharing ratio of the realized
positive outcome at the end of the business, not the rate
of return on the loan itself that is predetermined in the
case of interest. While profit is a result of a positive result
of the business and in proportion to it, interest has nothing
to do with the result of the business regardless it is a
positive or a negative sum game.
Islamic banks normally operate three broad
categories of account, mainly current, savings, and
investment accounts. The current account, as in the case
of conventional banks, gives no return to the depositors.
It is essentially a safekeeping (alwadiah) arrangement
between the depositors and the bank, which allows the
depositors to withdraw their money at any time and
permits the bank to use the depositors’ money. Cheque
books are issued to the current account deposit holders.
Islamic banks provide the broad range of payment
facilities clearing mechanisms, bills of exchange,
travelers’ cheques, credit/bank cards etc.
The savings account is also operated on an al-
wadiah12 basis, but the bank may pay the depositors
12 Al-wadiah is safe-keeping with guarantee. It refers to money or goods deposited with another person for safe-keeping. As al-wadiah
is a trust, the depository guarantees repayment of the whole amount of the deposit when demanded. The depositors are not entitled to any
share of the profits but the depository may provide returns to the depositors as a token of appreciation.
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Ismail Ozsoy
a positive return periodically at its absolute discretion,
depending on its own profitability. Such payment is
considered lawful in Islam since it is not a condition
for lending by the depositors to the bank, nor is it
predetermined. The savings account holders are
issued with savings books and are allowed to
withdraw their money as, and when, they please.
(Ariff, 1988, 51)
The investment account is based on the mudaraba
principle, and the deposits are term deposits which cannot
be withdrawn before maturity. If withdrawn, no profit is
paid. The profit-sharing ratio varies from bank to bank
and from time to time depending on supply and demand
conditions.
At the investment portfolio end of the scale, Islamic
banks employ a variety of instruments. The mudaraba
and musharaka modes are supposedly the main channels
for the outflow of funds from the banks. In practice,
however, Islamic banks have shown a strong preference
for other modes which are less risky. The most commonly
used mode of financing seems to be the ‘mark-up’ device
which is termed murabaha.
In a murabaha transaction, the bank finances the
purchase of a good or asset by buying it on behalf of its
client and adding a mark-up before reselling it to the client
on a ‘cost-plus’ basis. It may appear at first glance that
the mark-up is just another term for interest as charged
by conventional banks, interest thus being admitted
through the back door.
What makes the murabaha transaction legitimate is
that the bank first acquires the asset and it assumes certain
risks in the process between purchase and resale. The
bank takes responsibility for the good before it is safely
delivered to the client. The services rendered by the
Islamic bank are therefore regarded as quite different
from those of a conventional bank, which simply lends
money to the client to buy the good, and which is mostly
not interested in how and where the loan is used other
than securing the return of the loan with some measures
such as collaterals and mortgages.
Leasing or ijara is also frequently practiced by
Islamic banks. It means selling benefit or use or service
for a fixed price or wage. Under this mode, the banks
would buy the equipment or machinery and lease it out
to their clients who may opt to buy the items eventually,
in which case the monthly payments will consist of two
components, i.e., rental for the use of the equipment and
installments towards the purchase price.
Islamic banks have also been resorting to purchase
and resale of properties on a deferred payment basis,
which is termed bai’ muajjal. It is considered lawful in
fiqh (jurisprudence) to charge a higher price for a good
if payments are to be made at a later date. According to
Islamic law, it is not interest, since it is not a lending
(money-for-money) transaction but a trading one (money-
for-goods). Here, the higher price corresponds to the
earlier use value of the property by the client rather than
saving money first for a period of time and then buying
the property on his behalf, thus having to postpone the
use value of it.
A pre-paid purchase of goods, which is termed
salam, is a means used to finance production by Islamic
banks. Here the price is paid at the time of the contract
but the delivery takes place at a future date. This mode
enables entrepreneurs to sell their output to the bank at a
determined price in advance.
Similar the salam, but more extended than it,
istisna’a is a contractual agreement for manufacturing
goods and commodities, allowing cash payment in
advance and future delivery. It can be used for providing
the facility of financing the manufacture or construction
of houses, plants, projects, and building of bridges, roads,
and highways.
These are basic modes of Islamic banking.
Similarities with conventional banking are only
superficial resemblances since Islamic banking is
necessarily based on real businesses. Notwithstanding
the areas of operation, differences lie in the modes of
transactions and their associated practical arrangements.
For example, whereas an Islamic bank may charge a
fixed markup in murabaha financing, the thing provided
may not be repossessed, payment delays/defaults will
not justify any compensatory claims, and the client may
not claim rebates for early settlement. Of course, the
bank can make recourse to some covers in order to
protect its financing.13
These modes of Islamic finance, especially
mudaraba, were practiced predominantly in the Muslim
world throughout the Middle Ages, fostering trade and
business activities. In Spain and the Mediterranean and
Baltic States, Islamic merchants became indispensable
middlemen for trading activities. It is claimed that many
concepts, techniques, and instruments of Islamic finance
were later adopted by European financiers and
businessmen.14 The commenda of the Medieval Europe
was originally the Muslim mudaraba contract as forcefully
13 Tahir Sayyid.(2007). “Islamic Banking Theory and Practice: A Survey and Bibliography of the 1995-2005 Literature”. Journal of
Economic Cooperation, 28,1 (2007), p. 21.
14 http://www.islamic-banking.com/ibanking/whatib.php, accessed on Oct 10, 2008.
146
Економічний вісник Донбасу № 4 (22), 2010
Ismail Ozsoy
argued by Udovitch,15 and by Ashtor.16 As a form of
partnership, the commenda was most common in the
sea trade of the Mediterranean, but it was also used in
overland travel. In Genoa and other Italian cities, as early
as the twelfth century many individuals who were not
actually active in trade invested in trade by this means.17
A recent International Monetary Fund study by Iqbal
and Mirakhor (l987) has found Islamic banking to be a
viable proposition that can result in efficient resource
allocation. The study suggests that banks in an Islamic
system face fewer solvency and liquidity risks than their
conventional counterparts.18
Islamic banking is steadily moving into an increasing
number of conventional financial systems. Today, Islamic
banking is estimated to be managing funds to the tune of
US$ 200 billion.19 According to another estimate, the
volume of Islamic financial assets has reached US$ 500
billion, even to another it is US$ 750.20 Its clientele are
not confined to Muslim countries but are spread over
Europe, United States of America and the Far East.
Islamic banking continues to grow at a rapid pace because
of its value-orientated ethos, which enables it to draw
finances from both Muslims and non-Muslims alike.
Islamic bankers, keeping pace with sophisticated
techniques and latest developments have evolved
investment instruments that are not only profitable but
are also ethically motivated.
In fact there are currently more than 300 Islamic
financial institutions operating world-wide and spread
over more than 50 countries including non-Muslim as
well as Muslim countries, plus well over 250 mutual
funds that comply with Islamic principles. A mutual
fund is an investment company that pools the money of
many individual investors to purchase stocks, sukuk or
other financial instruments. Over the last decade, this
industry has experienced growth rates of 10-15 percent
per annum -a trend that is expected to continue. 21 The
size of the total Islamic financial assets is estimated to
reach US$ 1 trillion.22
The countries where Islamic financial institutions
are functioning include: (in alphabetical order) Albania,
Algeria, Australia, Bahamas, Bahrain, Bangladesh, British
Virgin Islands, Brunei, Canada, Cayman Islands, North
Cyprus, Djibouti, Egypt, France, Gambia, Germany,
Guinea, India, Indonesia, Iran, Iraq, Italy, Ivory Coast,
Jordan, Kazakhstan, Kuwait, Lebanon, Luxembourg,
Malaysia, Mauritania, Morocco, The Netherlands, Niger,
Nigeria, Oman, Pakistan, Palestine, Philippines, Qatar,
Russia, Saudi Arabia, Senegal, South Africa, Sri Lanka,
Sudan, Switzerland, Tunisia, Turkey, Trinidad & Tobago,
United Arab Emirates (Abu Dhabi, Dubai, Sharja), United
Kingdom, United States, Yemen.23 Similarly, countries like
India, the Kyrgyz Republic, and Syria have recently
granted, or are considering granting, licenses for Islamic
banking activities.24
Conclusion
The issue of interest is a complication to all the
economies and a problem for all the mankind. Since it is
naturally a reason for an unavoidable inequitable distribution
of income in any interest bearing transaction, Quran
explicitly identifies interest with injustice either for borrower
or lender and rejects it as a way of income distribution
Interest is an unearned income when realized rate
of return is lower than initially determined interest rate
and an unequally distributed income when realized rate
of return is unexpectedly higher than initially determined
interest rate. Since a middle way that both parties are
equally satisfied is one of too many probabilities, any
interest rate, like a both-sided cutting saw, is a reason
for an unavoidable financial loss for either party; therefore
it is prohibited by Quran in order to protect financial rights
of borrower and lender in an all-embracing manner.
Interest also represents the allocation of an imaginary
income, which is assumed to have been born out of the
15 Udovitch, A. L. (1962). “At the Origins of the Western Commenda: Islam, Israel, Byzantium”, Speculum 37, pp. 198-2007. See also,
Cizakca, Murat. 196). A Comparative Evolution of BusinesPartnerships, the Islamic World and Europe with Specific Reference to the
Otoman Archives, Leiden: E. J. Brill.
16 Ashtor, E. (1977). “Banking Instruments between the Muslim East and the Christian West”, Jounal of European Economic History,
1977/1, pp. 553-3.
17 Cameron, Rondo.(1997). A Concise Economic History of The World, 3rd Ed., Oxford University Press, p. 67.
18 Ariff, Mohamed. (1988). “Islamic Banking”, Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), p. 55, available at
http://www.witness-pioneer.org/vil/Articles/economics/islamic_banking.html#litpra, accessed on Oct 10, 2008.
19 http://www.islamic-banking.com/ibanking/ifi.php, June 20, 2009.
20 Katilim Bankalari 2008 (Participatory Banks 2008). Turkiye Katilim Bankalari Birligi (Association of Participatory Banks of
Turkey), Istanbul, p. 30.
21 Solé , Juan. (2007). “Introducing Islamic Banks into Conventional Banking Systems” IMF Working Paper, Monetary and Capital
Markets Department, July 2007, WP/07/175, p. 3.
22 Katilim Bankalari 2008, ibid.
23 http://www.islamic-banking.com/ibanking/statusib.php accessed on Oct 10, 2008.
24 Solé , ibid.
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Ismail Ozsoy
exchanges of the derivatives on the basis of their nominal
values. Thus, the main reasons for the recent financial
bubble that resulted in the Global Financial Crisis of 2008
can be said to be the interest bearing transactions, in the
Islamic sense, of the financial derivatives.
That unacceptable nature of interest has given way
to the introduction and development of Islamic banking
based on so many substitutions for interest available in
Islamic economics.
In Islamic economics interest is replaced with so many
other options based on the kinds of participation, trade,
exchange, and leasing in a way that no need is left to interest.
Thus, interest income is substituted for profit, rental, wage,
commission; each having a concrete consideration of value
in the economic sense in contrast to interest that has not
any comparable equivalent in loans or exchanges.
With a different function depending on the client’s
situation Islamic bank sometimes acts as trader and
provides capital financing through the salam or istisna’
modes, and recover its financing by having standing
arrangements with final buyers for things produced in
the name of the bank against the financing. It may adopt
the option of ijara if the client is interested in leasing an
asset. It can provide financing on partnership basis -
mudaraba or musharaka.
Islamic banking mostly favors the modes of profit
loss sharing and equity participation. However, since these
modes of business activities demand such humanistic/
ethical values as trust, honesty, integrity and
professionalism, they are the limits to the ultimate success
of interest free banking in all societies.
Even in its present form that prefers risk free or
less risky kinds of transactions, Islamic banking can
be taken as a considerable step and an opportunity for
the whole mankind towards a more equitable world.
This is because Islamic banking, with its interest-free
and real value based character, does not seem to create
at least financial bubbles the interest mechanism has
caused recently, and may cause any time; the bubbles
that, once they can not be sustainable and burst
eventually, shake all the global markets. It has
something to give all.
The attachment of Islam to the equal distribution of
income by prohibiting the interest, one of the most
influential reasons for the unequal distribution of income
and the discouraged investment, can be said to help
alleviate the problem of poverty since the equal distribution
of income causes the aggregate demand to increase,
which gives way to an increase in the aggregate supply,
aggregate output and employment. Moreover, crisis-
preventive nature of interest-free policies contributes to
the economic stability and the common welfare.
More importantly, Islamic banking can be a bridge
between the Western communities and the Muslim
societies, thereby contributing to the world peace as well
as the common welfare. The roots of this cooperation
are available in the common origins of the Jewish,
Christian and Islamic traditions that prohibit interest.
Resisting the interest for 1500 years, longer than the
lifetime of Islam since its birth, the Vatican accomplished
its historic mission by referring to the Islamic banking
system to the current western financial world,25 which
can be regarded as the beginning of a new age when the
whole mankind can expect a better future in terms of
peace and socio-economic welfare for all.
References
1. Al Gamal, Mahmoud Amin. (2000). A Basic
Guide to Contemporary Islamic Banking and Finance.
Rice University. June 2000. 2. Ariff Mohamed. (1988).
“Islamic Banking”, Asian-Pacific Economic Literature,
Vol. 2, No. 2 (September 1988), pp. 48-64, available at
h t t p : / / w w w . i s l a m i c i t y . c o m / f i n a n c e /
IslamicBanking_Evolution.htm. 3. Ashtor E. (1977).
“Banking Instruments between the Muslim East and the
Christian West” // Jounal of European Economic History.
— 1977/1. — pp. 553-3. 4. Bö hm-Bawerk Eugen.
(1897). “The Origin of Interest”, Quarterly Journal of
Economics, vol. 10, available at
http://socserv.mcmaster.ca/econ/ugcm/3ll3/bawerk/
interest.htm, June 17, 2009. 5. Cameron Rondo.(1997).
A Concise Economic History of The World, 3rd Ed.,
Oxford University Press. 6. Chapra M. Umer. (l982).
“Money and banking in an Islamic economy” in Monetary
and Fiscal Economics of Islam, ed. M Ariff, International
Centre for Research in Islamic Economics, Jeddah.
7. Cizakca Murat. 196). A Comparative Evolution of
BusinesPartnerships, the Islamic World and Europe with
Specific Reference to the Otoman Archives, Leiden:
E. J. Brill. 8. Homoud Sami Hassan. (1985). Islamic
Banking: The Adaptation of Banking Practice to Conform
with Islamic Law, Arabian Information Ltd, Cambridge
University Press, London. ISBN: 0-86010-503-2.
9. http://en.wikipedia.org/wiki/Economic bubble,
accessed on Nov 27, 2008. 10. http://www.islamic-
banking.com/ibanking/ifi.php, June 20, 2009.
25 “Vatican backs Islamic finance”, available at http://www.newhorizon-islamicbanking.com/
index.cfm?section=news&action=view&id=10751, May 20, 2009; “Vatican offers Islamic finance system to Western Banks”, March 6,
2009, available at http://www.worldbulletin.net/news_detail.php?id=37814, May 20, 2009; “Vatican Paper Supports Islamic Finance.
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11. http://www.islamic-banking.com/ibanking/
statusib.php, accessed on Oct 10, 2008.
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whatib.php, accessed on Oct 10, 2008.
13. http://www.statemaster.com/encyclopedia/Time-
value-of-money accessed June 20, 2009. 14. Katilim
Bankalari 2008. (Participatory Banks 2008). Turkiye
Katilim Bankalari Birligi (Association of Participatory
Banks of Turkey), ?stanbul (in Turkish)
(www.tkbb.org.tr). 15. Muslim Abu’l-Huseyn b. al-
Hajjaj. (1955). Al-Jami’ al-Sahih, ed. M. Fuad Abdulbaki,
1. ed., 1374/1955 (in Arabic). 16. Ozsoy Ismail. (1995).
“Faiz (Interest)”, Islam Ansiklopedisi (Islamic
Encyclopedia), Tü rkiye Diyanet Vakfı, Vol: XII-110-26
(in Turkish). 17. Solé Juan. (2007). “Introducing Islamic
Banks into Conventional Banking Systems” IMF
Working Paper, Monetary and Capital Markets
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www.imf.org/external/pubs/ft/wp/2007/wp07175.pdf,
accessed on Nov 30, 2008. 18. Tahir Sayyid. (2007).
“Islamic Banking Theory and Practice: A Survey and
Bibliography of the 1995-2005 Literature”, Journal of
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Quran. 20. Udovitch A. L. (1962). “At the Origins of
the Western Commenda: Islam, Israel, Byzantium”,
Speculum 37, pp. 198-2007. 21. “Vatican backs Islamic
finance”, available at http: //www.newhorizon-
i s l a m i c b a n k i n g . c o m /
index.cfm?section=news&action=view&id=10751,
May 20, 2009. 22. “Vatican offers Islamic finance system
to Western Banks”, March 6, 2009, available at
http://www.worldbulletin.net/news_detail.php?id=37814,
May 20, 2009. 23. “Vatican Paper Supports Islamic
Finance. France Wants Its Share of Sharia Banking”,
available at http://www.brusselsjournal.com/node/3819,
May 20, 2009. 24. Wikipedia contributors, “Economic
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index.php?title=Islamic_banking&oldid=170724439
(accessed November 13, 2007).
Ismail Ozsoy. Islamic banking: conceptual
fundamentals and basic features
Islamic banking is a phenomenon of the finance and
banking world in the recent decades. Rejecting interest policy
as an instrument for any business activity, Islamic banking
is based on the substitutions for interest that are profit, rental,
commission, and wage, all of which are regarded as legitimate
earnings of trade, its derivatives, joint venture and
partnerships, leasing, and other lawful and real economic
activities. Before explaining the interest free finance and
banking methods, this paper first criticizes the interest policy,
tries to uncover its nature, and its prohibition reason by the
Quran. Then, it makes brief ‘interest-rental’ and ‘interest-
profit’ comparisons. The paper also deals with the
foundations and some basic characteristics of Islamic
banking together with its practical appearances in the world.
Key words: interest/usury, Islamic/interest-free
banking.
Ісмаїл Осзой. Мусульманська банківська
справа: концептуальні принципи та особливості
Мусульманська банківська справа — явище, що
набуло поширення у фінансовому та банківському світі
в останні десятиліття. Відкидаючи вигідний поліс, як
інструмент для будь-якої ділової активності, Мусуль-
манська банківська справа заснована на замінах для
інтересу у вигляді доходу, рентного доходу, комісії,
заробітної плати, що розцінюються як законна виручка
від торгівлі, спільних підприємств і товариств, оренди
та іншої законної і реальної господарської діяльності.
Автор статті критикує вигідний поліс, намагається роз-
крити його природу та причину заборони кораном.
Ключові слова: інтерес/лихварство, Мусуль-
манське/безвідсоткове банківське діло.
Исмаил Осзой. Мусульманское банковское
дело: концептуальные принципы и особенности
Мусульманское банковское дело — явление, по-
лучившее распространение в финансовом и банковс-
ком мире в недавние десятилетия. Отвергая выгод-
ный полис как инструмент для любой деловой актив-
ности, Мусульманское банковское дело основано на
заменах для интереса в виде дохода, рентного дохода,
комиссии, и заработной платы, которые расценивают-
ся как законная выручка от торговли, совместных
предприятий и товариществ, аренды и другой закон-
ной и реальной хозяйственной деятельности. Автор
статьи критикует выгодный полис, пробует вскрыть
его природу, и причину запрещения кораном.
Ключевые слова: интерес/ростовщичество, Му-
сульманское/беспроцентное банковское дело.
Received by the editors: 18.10.2010
and final form in 01.12.2010
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