How Islamic Banks Operate

Where the normal banking practices do not clash with the Islamic principles, the Islamic banks have adopted the current banking tools and procedures. Where any clash arises, the Islamic banks have devised their own tools and procedures to accomplish their banking activities. Such tools and procedures that have been devised so far are enumerated below:

A. Deposits

Islamic Banks receive two types of deposits:

  1. deposits not committed for investment which take the form of current accounts or savings accounts, and
  2. deposits committed for investment which are called Investment Accounts.

Whereas Current Account is operated in the same way as it is operated in the conventional banking system, the Savings Accounts and Investment Accounts are operated differently as discussed below:

Savings Accounts

This is an account where the customers can deposit their savings. Though these depositors allow the banks to use their money, they get a guarantee of getting their full amount bank from the bank. In this case, the Bank guarantees their savings but is not obliged to pay any rewards to the savers. However, most of the banks are still paying either a cash reward from their profits at the end of their financial year or are giving some privileges to the holders of these accounts, e.g. providing financial support for small projects, sale of consumer durables or producers goods by instalments, distributing gifts etc. These rewards are discretionary and not obligatory and are paid only in case the bank is earning substantial profits. These accounts, however, were found to be attracting relatively very little deposits but some of the Islamic Banks (Kuwait Finance House and Dubai Islamic Bank, for example) were giving a significant profit (ranging between 5 to 6 per cent) on these accounts. On accounts that have no risks, this much profit is not understandable. Without facing any risk of loss, how can they share in the profit? The Savings Accounts share the net profit of the bank according to some agreed proportion.

Investment Accounts

These Investment Accounts can be of two types:

  1. Accounts with authorisation, and
  2. Accounts without authorisation.

In the accounts with authorisation, the account holder authorises the bank to invest this money in any one of its projects. After the expiry of a specified period, the account holder will get the profit. In case of investment accounts without authorisation, the account holder may choose any particular project for investment of his deposited money. (The account holder, may or may not specify the period of deposit.) The bank will give share to the account holder from the profit of that particular project which has been chosen by him according to agreed percentage. If the investment accounts are opened for a fixed period, the customer is not allowed to withdraw his money before the lapse of the specified period. If he does so, the customer either is not entitled to the share in profit at all or may be entitled to receive some discounted profit depending upon the duration of the deposit with the bank. These deposit schemes of Islamic banks have been able to attract a substantial number of depositors. The current annual report of Kuwait Finance House indicated that their number of account holders have reached a level of over 20,000 within a 2-year period which has surpassed their prediction based on the trend of the deposits cf the other interest-based banks that were established in Kuwait. The amount of deposits in these accounts has shown even a higher increase. During 1979, the number of Savings Accounts in their bank increased by 255 per cent whereas the amounts of deposits in these accounts increased by 377 per cent. Other Islamic banks also have shown quite a respectable growth in their deposits. The deposits in four major Islamic banks which have been in operation for more than two years have now reached a level of more than 500 million U.S. dollars. These deposits registered a growth of about 150 per cent during 1979 which is a respectable growth when compared with the growth in the deposits of interest-based banks of similar vintage working in same areas.

Investment accounts are generally popular in these banks. Savings Accounts are equally popular only in those banks where these accounts are entitled to share the profits of the bank. Where the Savings Accounts are not entitled to share the profits, the deposits in these accounts are negligible.

B. Investment Activities

As the bank cannot earn interest by lending the money, therefore, the Islamic banks have to undertake investment to earn profit not only for the bank itself but also for the depositors in the investment account. The investment procedures based on the Islamic principles are given below

Musharkah (Equity Participation)

The banks and their clients agree to join in a temporary participation (not quite different from the joint venture concept) for effecting a certain operation within an agreed period of time. Both parties contribute to the capital of the operation (taken to mean, assets, technical and managerial expertise working capital etc.) in varying degrees and agree to divide the net profit in proportions agreed upon in advance. There is no set formula for profit-sharing and each case is dealt with on its own merits. Operations carried, according to this mode, can vary from weeks to years. In medium- and long-term operations, a self- liquidating form of participation can be agreed upon; whereby the ownership of the whole project or operation may pass to the partner (customer). The bank would have retrieved, in the meantime, an agreed share of profits. The bank may also permanently participate in any ir.iding establishment or building or factory or agriculture till the liquidation of the firm, or may participate temporarily promising to with- draw its share by selling the same to the partners (and partners also promising the same) by paying the bank’s amounts at once or on instalments as per mutual agreement among them. This procedure is also being applied to a few activities other than the investment project. Some of these activities are:

  1. Letter of Credit. If the importer fails to pay the full amount of the letter of credit at the time of the delivery of goods, the bank will not charge him any interest on postponing the payment and will instead, share in the profits of the importer at a ratio agreed upon in advance. Some of the Islamic banks, however, charge nothing if the amount is paid in full at the time of the delivery.
  2. Purchase of Property or Real Estate. The bank may provide loans for such purchases on the'basis of musharkah. The bank will assess the rent or annual income from the property or real estate and will share it according to the extent to which he is financing and according to the terms agreed in advance. As the client pays up the instalments of the loan, the bank’s share in the income will be reduced till the whole property is transferred to the client.

Mudarabah or Qiradh (Agencies)

In this procedure of investment, bank contributes all the financing (and the customer contributes only his managerial efforts or labour) and gets again an agreed proportion of the profit actually realized. In both mudarabah and musharkah, both sides stand to incur any profit depending on the actual performance of the operation. In the mudarabah contract, however, the mudarabah (the partner offering his effort) will lose nothing but his labour (as the principal capital is not his) in case of financial loss resulting from normal business conditions. The bank who has financed the capital bears all the finance risks. This finance risk justifies the bank to claim his share in the profit. The client is, however, held responsible for the loss of capital, should this be the result of his negligence or wilful act. To guard against this, the bank may require a security from the customer.


This is a procedure where a partner approaches the bank that certain items (be it a commodity or otherwise) be bought for him and he agrees to pay the bank later on, upon the fulfilment of the actual buying, din agreed percentage of profit. In order to avoid any riba element one of the banks provides that the agreement of the bank and the actual execution of buying do not contribute any legal obligation (according to Shari'ah) on the partner to buy. Hence the risk is still that of the bank’s. Until the partner fulfils his original promise of “rebuying” the commodity, the risk remains with the bank which justifies the profit. There is, however, also the practice of financing a mark-up with the binding on the buyer to buy the goods. This type of operation is most commonly being used in foreign trade and short-term transactions for purchasing raw materials etc. for the industrial establishments.

Bai Salam (Post Delivery Sale)

The bank buys certain goods on post delivery and pays the cost immediately or sells certain goods on post delivery and receives its cost immediately. In this sale, cost of goods is fixed and paid in advance but the delivery of the sold iterrr.ivpostponed or delayed up to a certain period. Similarly, the place of delivery, its expenses and quantities of the sold goods should also be fixed and defined as they are conditions for such a sale.

Leasing or Renting the Physical Capital/Equipment

The bank, in this case, purchases a physical capital/equipment and rents it to his client. This procedure can be converted into a reduced renting procedure whereby the customer, by paying every year an instalment of the value of equipment/physical capital, reduces the rent, till the whole equipment is owned by him and the rent is eliminated.

These tools of investments have theoretically been designed to apply to all sectors of the economy but in practice the investment activities have been found to be concentrating only to real-estate and trade sectors. Kuwait Finance House during their two years of operation concentrated on real-estate. This shared 100 per cent of their investment in 1978 and 94 per cent in 1979. This included rented residential buildings. Similarly, Dubai Islamic Bank described their operational strategy as “to prefer for projects which give quick returns”.

Technically these banks are also supposed to invest in long-term and medium-term projects but practically most of their investment is short- run, perhaps, because of the prevalent trend in local markets (in the Middle East).

Mudarabah is more popular form of investment by the Islamic banks. Generally the banks have been found to be able to make 10 to 14 per cent profit on their investment activities. The Tables 1-3 show the profits on investment activities of some of the Islamic Banks:


Islamic Investment Company of the Gulf

.July 31, 1980


Date of issue



Increase since inception


1980 annualised increase per S 100

1st mudarabah 3 years 2nd mudarabah (profits





paid 31.5.80)





3rd mudarabah

•J. 10.79




4th mudarabah





5th mudarabah 1 year





6th mudarabah 3 years





Monthly institutional mudarabah

Month of July






Faisal Islamic Bank of Sudan

Dec. 31, 1979

Average profit on Investment Activities: 13.5 per cent.

C. Bonds and Securities 

Al-Muqardha Bonds

This tool is utilized when a large amount is needed for a big project. The bonds carry shares in the profits of the project. An amount of the bond may be decreased in the same way as the participation is reduced in the case of Mudarabah or Musharkah or Renting. Two new Jordanian banking groups are working on the scheme to float “Income Bonds" to finance projects being built by the country's Ministry of Islamic Endowment and Religious Affairs. These bonds differ from the normal bonds in that they do not pay any guaranteed or fixed return to investors. The holders of the bond will take a percentage of the profits of the project that the bonds are financing. The basis of this bond is a participation contract through which one or more partners with their money (the beneficial owners) and another with his efforts (participant) get together to earn profit in a Halal trade. Profits will be divided between them on an agreed upon proportion.

Islamic Securities (Al-Mudarabah Certificates)

This is similar to the Islamic Bonds in nature and have the same basis as illustrated above. The Islamic Securities, however, are not issued for any specified project. Instead a Mudarabah (participation) company is established. This company issues a certificate which is a receipt for the money received and a guarantee by the Mudarabah Company to reimburse the proceeds of the company, if any, to the bearer of the certificate at the date of maturity and according to the amount with which he participated. These certificates, of course, bear the element of risk of losses, if any.

The Mudarabah Company will then invest all the money it receives in local or international enterprizes, in which it is conditioned that it must in -no way contradict with the rulings of Islamic Shari'ah. With the assistance of a selected group of internationally experienced businessmen in the field of investment and the supervision of leading scholars in SharVah, the Islamic Investment Companies have prepared various proforma {ox Mudarabah Certificates.

D. Loans

Loan Certificates

These are the certificates through which a Mudarabah Company receives Islamic Loans whose maturity is defined but which do not entail, in any way, share in the profits or losses. The Certificate is meant for such Muslims who do not want to take risk of investment but are willing to allow the use of their money for the benefit of and investment in the Islamic Community. Here the Muslim lender is shunning riba and is positively participating in a collective Islamic task aiming at spreading Islamic economy and above all the spreading of Allah’s words.

The reimbursement of these loans, however, have a priority and their amount is guaranteed.

The public investors have the option to combine both the portfolio (Mudarabah Certificate and Loan Certificate) according to their desire for investment and their preference for risk.

Benevolent Loans

These loans are provided by banks and the objective of these loans is to produce benefits either for the general public or for charity. There is no interest or return on these loans. Though there is, a provision for a service charge to cover the cost of providing the loan, yet no bank is applying this charge except the Islamic Development Bank in Jeddah. All the commercial banks provide loans free of any charge if they have any provision of such loans.

The serivce charge, whenever applied to a loan, is claimed to be different from interest on the ground that it is not a fixed percentage of loan, but it is an absolute amount calculated by working out actual costs in providing the loan.

So far, the Islamic Banks are not inclined to provide these loans. Only the Islamic Development Banks are providing such loans for the social and infra-structural projects. The commercial banks have, however, shown willingness to provide personal non-productive loans without any charge after they get properly established and have accumulated enough funds. The criterion for the advancement of such loans will be based on:

  1. The nature of the need for which the loan is required.
  2. The credit of the client with the bank.

Thus an old client of the bank requiring loan for his son’s education will have a priority over the new client requiring loan to buy an air- conditioner.

  1. Short-term Loans

To meet short-term loan/credit requirement of the enterprises, the banks do have the provision to provide such loans without interest or any other charge. However, this too has not been very much in practice. The criterion for advancing such loans theoretically, is:

  1. Specific credit needs of the firm.
  2. Social priority attaching to the enterprise.
  3. Nature of the security against loan.
  4. Whether the credit seeker has also obtained term advances from the bank for the same enterprise.
  5. Annual, monthly or weekly average of the applicant’s balance in current account with the same bank.

Generally, the banks do not encourage the customers to overdraw. In special cases, this may be allowed with the fixation of the maximum date to adjust the said drawn amount. No interest or expenses are charged on such loans. This is treated as qard-hasanah.

Bills of Exchange

Bills of exchange are also treated under the mudarabah principles. Cash is provided against the bill on the condition of a claim in the profits from the. sale of merchandise. An interest-free loan may also-* be advanced. No discounts are allowed in either case.

E. Insurance and Underwriting 

Cooperative Insurance

Some of the banks are undertaking insurance as a subsidiary business of their organisation. This insurance is a sort of cooperative insurance. The principle is that all the losses have to be borne by the participants on cooperative basis. The participants will, however, share the profit arising out of the investment of the premium. This principle is being applied to life insurance too. The procedure is that all the participants (policy holders) at the maturity of their policy get all the amount that they had paid as premia plus the share in profit. If a policy holder dies before the maturity of his policy, he gets all the amount that he paid as premium plus the share in profits plus the remaining amount of the policy to be contributed by all the other participants. The participants contribute not only as part of their social obligation but also because they will get the same treatment.

F. Profitability of Islamic Banks

All Islamic Banks are maintaining a satisfactory level of profitability. The profit rate on capital is ranging from 9 per cent to above 20 per cent. This compares almost at par with interest-based banks in their areas. On investment deposits the profits have been paid at the rate of 8 to 15 per cent.

G. Relationship with other Banks

Islamic banks are doing business with other banks also in their countries strictly on Islamic principles. The working of Islamic banks has impressed the other banks even in non-Muslim countries particularly those in Europe which are now devising ways and means to do business with Islamic banks.


Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.
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