How Do Islamic Banks Work?

Islamic Banking refers to a system of Banking or Banking activity that is based on the principles of the Shari'ah (Islamic rulings). According to the principles of Shari'ah, the bank is not allowed to enter into or any act that involves (give and take of) interest.
The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or by lending to someone else.

Hence, a frequently asked question is - how do Islamic banks make money if they cannot charge interests? The principal means of Islamic finance is based on trading, hence, banks can profit from the buying and selling of Shari'ah Compliant goods and services. Islamic financial institutions trade in Shari'ah-compliant investments with the money deposited by customers, sharing the risks and the profits between them.

Several structures that help Islamic Banks make a profit are:

a) Ijara: Here, the bank buys an asset on behalf of the customer and leases it out to the same customer. Ownership of the asset remains with the bank, which is also responsible for its maintenance. The lease agreement is made for a certain period and after the time period gets over (and all the lease is paid off); the asset is transferred to the customer.

b) Murabaha: Here the bank acts as an intermediary and buys an asset like a motor vehicle. This property is then sold to the customer at cost plus profit which is known and agreed upon. The customer pays back the value in deferred payments.

c) Wakala: The term wakala is used in Islamic finance to describe a contract of agency or delegated authority pursuant to which the principal (muwakkil) appoints an agent (wakeel) to carry out a specific task on its behalf. Here, the bank works as an individual agent. The bank lends its expertise and manages investments of the customer on behalf of the customer for a particular duration, in order to generate an agreed-upon profit return.

d) Salam: As per the Salam structure, the Bank pays a purchase price to the customer for the upfront purchase of a fungible commodity which will be delivered on a deferred basis by the customer. The commodity that is to be delivered to the Bank will be purchased by the customer through a commodity broker and the Bank in turn will assign another commodity broker to sell the commodity.

The above-mentioned points help a bank generate revenue through Islamic Banking. These days, more and more people are moving towards Islamic Banking and consumers worldwide are appreciating the principles of Islamic Banking.

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