Al Islami FAQs

Islamic banking is defined as a banking system which is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Islamic Sharia.

Riba is a technical term in Islamic Sharia. It refers to ‘anything paid/charged over and above the principal amount on a loan’. It is an undisputed and agreed upon definition of Riba and is backed up by the consensus of all Islamic scholars and schools of jurisprudence.

It is used in this specific sense in Islamic Sharia and does not include all forms of exploitation, even though Islam prohibits all forms of exploitation. However, Riba is a technical term and refers to a particular type of exploitation in a loan transaction when something over and above the principal is taken or is charged.

A Sharia Board comprises of Islamic scholars who are experts in Islamic jurisprudence. It has the task of ensuring compliance to Islamic principles in products offered by Islamic Financial Institutions (IFIs).

All the products offered by IFIs have to be vetted by the Sharia Board. Their verdict and judgment is binding on the management and their presence and affiliation with IFIs provide a level of comfort to the customers of IFIs.

Islamic Finance is a set of financial institutions and instruments which comply with certain Islamic principles and avoid certain Islamic prohibitions. Its main features include but are not limited to:

• Prohibition of Riba.
• Prohibition of Gharar (excessive uncertainty) in sale transactions.
• Prohibition of Maysir and Qimar
• Prohibition of sale of Debt
• Prohibition of certain sale transactions like buy back, short selling etc.

There are at least six basic principles which are taken into consideration while executing any Islamic banking transaction. These principles differentiate from a financial transaction, a Riba/interest based transaction to an Islamic banking transaction.

Sanctity of contract: Before executing any Islamic banking transaction, the counter parties have to satisfy whether the transaction is halal (valid) in the eyes of Islamic Sharia. This means that Islamic bank’s transaction must not be invalid or voidable. An invalid contract is a contract, which by virtue of its nature is invalid according to Sharia rulings. Whereas a voidable contract is a contract, which by nature is valid, but some invalid components are inserted in the valid contract. Unless these invalid components are eliminated from the valid contract, the contract will remain voidable.

Risk sharing: Islamic jurists have drawn two principles from the saying of prophet Muhammad (SAW). These are “Alkhiraj Biddamaan 21 ” and “Alghunun Bilghurum22”. Both the principles have similar meanings that no profit can be earned from an asset or a capital unless ownership risks have been taken by the earner of that profit. Thus in every Islamic banking transaction, the Islamic financial institution and/or its deposit holder take(s) the risk of ownership of the tangible asset, real services or capital before earning any profit there from.

No Riba/interest: Islamic banks cannot involve in riba/interest related transactions. They cannot lend money to earn additional amount on it. However as stated in point No. 2 above, it earns profit by taking risk of tangible assets, real services or capital and passes on this profit/loss to its deposit holders who also take the risk of their capital.

Economic purpose/activity: Every Islamic banking transaction has certain economic purpose/activity. Further, Islamic banking transactions are backed by tangible asset or real service.

Fairness: Islamic banking inculcates fairness through its operations. Transactions based on dubious terms and conditions cannot become part of Islamic banking. All the terms and conditions embedded in the transactions are properly disclosed in the contract/agreement.

No invalid subject matter considered: While executing an Islamic banking transaction, it is ensured that no invalid subject matter or activity is financed by the Islamic financial transaction. Some subject matter or activities may be allowed by the law of the land but if the same are not allowed by Sharia, these cannot be financed by an Islamic bank.

Following are the most commonly used modes of Islamic banking and finance:

MURABAHA
Literally, it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him. The bank does that for a definite profit over the cost, which is stipulated in advance.

IJARAH
Ijarah is a contract in which the utility of certain goods or services of the persons are transferred against predetermined consideration. An example is taking a car or home on rent against some compensation.

MUSAWAMAH
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.

ISTISNA
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisna can be used for providing the facility of financing the manufacture or construction of houses, plants, projects and building of bridges, roads and highways.

MUDARABAH
A form of partnership where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne only by the provider of the capital.

MUSHARAKAH
Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic 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.

BAI SALAM
Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale cannot be gold, silver or currencies. Barring this, Bai Salam covers almost all good, which are quantifiable and defined by quality and worksmanship.

Conventional bank is a financial body which receives money from the depositors against fixed rate of interest and it offers liquidity to borrowers against interest. And it is governed by conventional banking laws.

Islamic Bank is a financial body which executes commercial contracts like sale, leasing, constructions and are governed by Islamic banking laws which allow for financial bodies to carry on commercial activities for profitable purposes.

The following are the main differential points between conventional banking and Islamic:

Conventional Banking

1. Money is a commodity besides being a medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out.

2. Time value is the basis for charging interest on capital.

3. Interest is charged even when the organization suffers losses by using the bank’s funds. Therefore, it is not based on profit and loss sharing.

4. While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made.

5. Conventional banks use money as a commodity which leads to inflation.

Islamic Banking

1. Money is not a commodity though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out

2. Profit on trade of goods or charging on providing service is the basis for earning profit.

3. Islamic bank operates on the basis of profit and loss sharing. In case, the businessman has suffered losses, the bank will share these losses based on the mode of finance used (Mudarabah, Musharakah).

4. The execution of agreements for the exchange of goods & services is a must, while disbursing funds under Murabaha, Salam & Istisna contracts.

5. Islamic banking tends to create link with the real sectors of the economic system by using trade related activities. Since, the money is linked with the real assets therefore it contributes directly tot economic development. 

The Islamic bank uses its funds in various trade, investment and service related Shariah compliant activities and earns profit thereupon. The profit earned from such activities is passed on to the depositors according to the agreed terms.

No, Islamic banks accept the deposits either on profit and loss sharing basis or on Qard basis. These deposits are deployed in financing, trading or investment activities by using the Shariah compliant modes of finance. The profit so earned by the bank is passed on to the depositors according to the pre-agreed ratio which, therefore, cannot be termed as interest.

No, it does not charge penalty in case of late payment as it is not allowed by Sharia, because it amounts to charging interest. However, in order to assure the creditor of prompt payment, the debtor may undertake to give some amount in charity in case of default. This is, in fact, a sort of Yamin (vow) which is a self-imposed penalty to keep oneself away from default. The amount received as charity is disbursed to charitable institutions and do not become part of the income of the bank.

Sukuks are Islamic investments certificates issued against shares in the underlying assets, whether existing or described assets promised to be delivered in future, or shares in the usufruct of such assets or shares in services.

Terms used in Islamic Finance how they differ from conventional banking:

Loan and Financing

As per Loan agreement, the borrower is solely liable to return money to the lender. However, financing is a commercial contract based on sale, leasing or construction. All banking products offered by Islamic banks are based on financing.

Borrower and Financee

Borrower is the person (or entity) who borrows money from someone. However financee is a person who agrees to settle a deferred price payable upon execution of a sale or lease contract.

Repayment & Payment

Installments paid by the Financier Customer in an Islamic bank represent payment of sale price, lease rentals or service charges. However installments paid by a borrower in a conventional bank represent repayment of a previously taken loan.

Late Payment Penalty and Charity Amount

Borrower in a conventional bank undertakes to pay penalty in case he delays in settling installments on due dates, These amounts are taken as additional profits for the bank. However Financee in an Islamic bank undertakes to pay an extra amount which goes for charitable purpose and the bank does not benefit from these amounts.

Loan Buyouts and Debt Settlement

Islamic bank offers liquidity- in a Sharia compliant way- to the customer which can help him settle his outstanding debt with the other bank. However conventional bank buyout the loan without any Sharia arrangement As per Sharia it is permissible to buy loan at discount or at premium.

Concept of Risk Bearing in Islamic Banking

All profits claimed by Islamic banks on its financings are based on the concept of risk bearing, where the bank as seller or lessor has to bear the risk of the underlying assets at the time of executing the financing contract with the customer.

Fiqh: Islamic law- the science of the Sharia. It is an important source of Islamic economics.

Gharar: Uncertainty. One of three fundamental prohibitions in Islamic finance (the other two being riba and maysir). Gharar is a sophisticated concept that covers certain types of uncertainty or contingency in a contract. The prohibition on Gharar is often used as the grounds for criticism of conventional financial practices such as short selling, speculation, futures and derivatives.

Fatwa A decree by a competent Sharia scholar qualified to issue decrees (muftW) on a matter giving an opinion about the position of a matter in the light of the Sharia rules and principles.

Maysir: Gambling. One of three fundamental prohibitions in Islamic finance (the other two being Riba and Gharar). The prohibition on maysir is often used as the grounds for criticism of conventional financial practices such as speculation, conventional insurance and derivatives.

Mudarib: The Mudarib is the entrepreneur or investment manager in a mudaraba who invests the investor's funds in a project or portfolio in exchange for a share of the profits. For example, a mudaraba is essentially similar to a diversified pool of assets held in a Discretionary Asset Management Portfolio.

Qard: A Qard is a loan, free of profit. We use this arrangement for our Current Accounts. In essence, it means that your Current Account is a loan to the bank, which is used by the bank for investment and other purposes. Obviously it has to be paid back to you, in full, on demand.

Riba: Interest. The legal notion extends beyond just interest, but in simple terms Riba covers any return of money on money - whether the interest is fixed or floating, simple or compounded, and at whatever the rate. Riba is strictly prohibited in the Islamic tradition. 

Takaful: Islamic insurance. Structured as charitable collective pool of funds based on the idea of mutual assistance, takaful schemes are designed to avoid the elements of conventional insurance (i.e., interest and gambling) that are problematic for Muslims.

Tawarruq: Reverse murabaha. As used in personal financing, a customer with a genuine need buys something on credit from the bank on a deferred payment basis and then immediately resells it for cash to a third party. In this way, the customer can obtain cash without taking an interest-based loan.

 Wakalah: Wakalah is an agency contract, which usually includes in its terms a fee for the expertise of the agent. We may use it for our large Deposit accounts: you own the capital invested, you appoint us as your agent and pay a fee for our expertise.

 al-‘aqd Legal contract implying an enforceable act involving a bilateral declaration, namely, the offer (’ Wjab) and the acceptance (Qabul).

bai‘ al-‘Inah A contract of sale where a person sells an article on credit and then buys back at a lesser price for cash.

al-bai‘ al-mu’ajjal A financing technique adopted by Islamic banks. It is a contract in which the seller allows the buyer to pay the price of a commodity at a future date in lump sum or in instalments.

bai‘ al-muqayadah Selling a commodity for another commodity.

bai‘ al-murabahah Sale of goods with an agreed upon profit mark up on the cost.

bai‘ al-musawamah Sale of goods at a price on which the buyer and seller agree after haggling without mentioning the cost to the seller.

Hibah: Gift.

al-’ijma‘ Consensus of the jurists (mujtahidwn) on a certain question in a certain age.

al-’ijtihad Endeavour of a jurist to derive or formulate a rule of law on the basis of evidence found in the sources.

al-kafalah A contract of surety in which a person adds to his responsibility or liability on behalf of another person in respect of a demand for something.

Wadia (Safekeeping): The safekeeping of goods with a discount on the original stated cost; resale of goods with a discount on the original stated cost; the acceptance of sums of money for safe-keeping a sharia-compliant frame work, under which it will be repaid, either on demand or in circumstances agreed by the parties involved, and which is not referable to the giving of security. Also see Al-wadia.

Wakalah, Wakil / wakalah bil ajr:Agency Contract, a sharia contract where a representative is appointed to undertake transactions on another person's behalf.