How Islamic banking works without interest


The Reserve Bank of India, in its annual report last week, has proposed to introduce interest-free banking in India. Through this system, which is also known as Islamic banking, the RBI wants to tackle the financial exclusion faced by Muslims.

What is Islamic banking?
Islamic banking has the same purpose as conventional banking systems but functions in accordance with the principles of Sharia, known as Fiqh al-Muamalat (Islamic rules on transactions). In India, it is based on Banking Regulation Act of 1949.

The Islamic principles prohibit charging and receiving of interest. Unlike the conventional banking system, which makes profit from charging interest on lending, Islamic banks make profits through investments.

Islamic banking in the modern world
There are some 350 Islamic financial institutions operating in 75 countries. Modern Islamic banking system was started in Egypt in 1963 by Ahmad El Najjar. Dubai Islamic Bank, established in 1975, is considered the first Islamic bank to have incorporated the principles of Islamic economics in its practice.

How it works
Islamic banks accept following types of accounts
1. Savings accounts
2. Investment accounts
3. Zakat accounts
In Islamic banking, a customer deposits his money in a specified account and the bank gives the guarantee to return the money, but no interest will be paid on savings accounts. The bank may charge the customer for looking after the money and it may pay hibah (gift) to the customer. The customer is allowed to withdraw the money on demand. This concept is normally used in deposit-taking activities, custodial services and safe deposit boxes.

Mudharabah (profit sharing)
Mudharabah is a profit sharing agreement between two parties—an investor and the entrepreneur. In Islamic banking, the investor funds the entrepreneur for business ventures and the returns will be based on profit, on the ratio that has been agreed upon earlier.

Mudharabah works in two ways—when a bank plays the role of an entrepreneur the customer becomes a capital provider. When customer plays the role of entrepreneur, the bank becomes a capital provider. In both cases losses suffered will be borne by the capital provider.

Musharakah (joint venture)
Musharakah refers to a partnership or a joint business venture to make profit. All the partners contribute capital to undertake a business activity. The partners share profits on a pre-agreed ratio, while losses are shared according to capital contribution.

Bai’ Bithaman Ajil (deferred payment scale)
Bai’ Bithaman Ajil works like the Equated Monthly Instalment (EMI) schemes of the conventional banking system. It is used by customers to purchase assets of substantial value in instalments, from which they can generate future cash flows. In this agreement, the customer gets the asset and is required to make payments as per the agreed tenure in instalments.

Qard (interest-free loan)
Under this agreement, a loan is given to a needy person without expecting any return or profit. The borrower is required to repay only the principal amount to the lender. However, the borrower may, if he so wishes, pay an extra amount (without promising it) as a way to thank the lender.

Hibah (gift)
Hibah refers to a payment made willingly in return for a benefit received, usually by the bank for the benefits it received from the savings accounts of customers. Unlike the interest rates, hibah cannot be guaranteed.

The Rajinder Sachar committee, appointed in 2005, found that the access of Muslims to bank credit is low and inadequate. The average amount lent per account to Muslims is about half that of other minorities. And a large number of Muslims are not fond of the conventional type of banking system. Introducing Islamic banking can make a difference to this mind-set.

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Topics : #RBI | #banking

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