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Theoretical Basis of Islamic Banking

In order to be justified Islamically, the banking system has to avoid riba. Consequently, much of the literature on theory of Islamic banking has grown out of concern that how monetary and banking system would function if interest is abolished by law. The literature on Islamic banking shows two different and distinct strands of thought. The literature developed in the Middle East, mostly in Arabic, is preoccupied with the functioning of a single bank and has adopted a micro approach. On the other hand, the literature developed in the Indian subcontinent, mostly in English, has generally taken a macro approach and has been concerned with the development of an interest-free banking system dealing with issues such as nature and functions of money in an Islamic economy, role, goals and instruments of monetary policy in an interest-free framework, etc. In this section, theoretical basis of Islamic banking will be briefly reviewed.

Modem commercial banking activity is based on the creditor-debtor relationship between the depositors and bank on the one hand and between the borrower and the bank on the other. Interest is viewed as the price of credit reflecting the opportunity cost of money. Islamic view about loan (qard) is that it should be given or taken, free of charge to meet any contingency and creditor should not take any advantage from the borrower. When money is lent on the basis of interest, more often than not, it ends up in some kind of injustice. The Islamic principle in these kinds of transactions is that “deal not unjustly, and ye shall not be dealt with unjustly” (al- Qur’an, 2:279). Hence, commercial banking in an Islamic framework could not be based on the creditor-debtor relationship.

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The other Islamic principle in the matters of financial transactions is that there is no reward without risk. This principle is applicable both to labour and capital. As no payment is al lowed to labour unless it is applied to work, no reward for capital should be allowed unless it is exposed to business risks.

Financial intermediation in an Islamic framework could take place using these two principles. Consequently, Islamic financial relationships are participatory in nature. It has been suggested by several theorists that commercial banking in an interest-free system be organised on the basis of principle of profit-sharing which is referred in the Islamic jurisprudence as mudarba.

The principle of mudarba could be explained by a simple illustration. Suppose there are two persons, one of them has capital but no special skills in trade, while the other has been bestowed with some special insight and dexterity in the matters of trade but possesses no capital. These two persons can cooperate in any one of the following two ways:

  1. The trader can borrow the money from the capital owner and invest in his trade. The capital owner shall get back his principal and an additional amount worked out on the basis of a fixed rate called interest rate as his compensation for parting with the liquidity. This is debt financing. Usually, the loan will be granted for a fixed period. The claim of the creditor for repayment of the principal and payment of the interest becomes viable only after the expiry of this period. This is irrespective of the fact whether the trader has made a profit using the borrowed money or not. In the event of a loss, the borrower has to repay the principal amount of the loan as well as the accrued interest from his own resources. This is viewed by Islam as an unjust transaction.
  2. The other possibility is that the two persons cooperate with each other not on a creditor-debtor basis but on the basis of partnership and cooperation in which the capital owner shall provide his capital and the other party will put his skill and management into trade. The capital owner shall not be involved in the actual and day-to- day operation of business but shall be free to stipulate eertain conditions which he may deem necessary to ensure the best use of his funds. After the expiry of the period which may be the termination of the contract or till such time that returns are obtained from the trade, the capital owner shall get back his principal amount along with a share of profit.

The ratio, in which the total profit of the enterprise is distributed between the capital owner and the manager of the enterprise, has to be determined and mutually agreed at the time of the contract before the beginning of the project. In the event of loss, the provider of the capital shall bear all the loss and the principal will be reduced by the amount of the loss. In a way, it is the possibility of the loss which makes the capital owner entitled for a share in the profit of the enterprise. This is in essence the principle of mudarba.

The Islamic legality of mudarba is based on the Sunnah as it is reported that mudarba was practised in the city of Madinah and elsewhere during the time of the Prophet (pbuh) and he did not disapprove of it.

The creditor-debtor relationship is viewed as an unjust one because it gives more leverage to creditor in contrast to debtor. The interests of creditor are protected at the cost of debtor. In contrast, the mudarba agreement is based on justice as it grants an equal position to both parties of the agreement.

There could be at least three reasons for considering mudarba relationship to be more just than the creditor-debtor relationship

First, both parties have an equal position in the determination of the ratio in which profits will be shared between them.

Second, treatment of both parties in uniform in the event of loss in which if provider of the capital suffers a reduction of his principal amount, the worker or manager in the mudarba contract is deprived of the reward of his labour, time and effort.

Third, both parties are treated equally if there is any violation of the agreement. If the worker or manager violates anyone of the stipulated conditions or if he does not work hard, or is instrumental in causing loss to the business due to negligence or bad management; he will have to bear the responsibility for the safe return of the whole amount in question. If on the other hand, provider of the capital violates any of the stipulated conditions (for example, he withdraws his funds before the stipulated lime, or docs not provide part or full funds at the promised time, etc.), he will have to pay the worker or manager a reward equivalent to what he would have earned in a similar work.

It has been suggested that mudarba be the basis of reorganising the banking activity, in an interest-free framework. This can be done by entering into a two-tier mudarba agreement which may be explained as follows:

The first tier of mudarba agreement is between the bank and the depositors who agree to put their money in the bank’s investment account and to share profits with it. In this ease the depositors are the provider of the capital and the bank functions as the manager of funds.

The second tier of mudarba agreement is between the bank and the entrepreneurs who seek finance from the bank on the condition that profits accruing from their businesses will be shared between them and the bank in a previous mutually-agreed proportion, but the loss is borne by the financier only. In this case the bank functions as the provider of capital and the entrepreneur works as the manager. In case there are more than one financier of the same project, i.e. one project is jointly financed by several banks, profits shall be shared in mutually-agreed proportion previously determined but loss shall be shared in the proportion in which different financiers have invested their capital. There could also be a partnership (sharikah) agreement between the bank and the ... in which loss is to be shared by the contracting parties in the proportion in which they have invested their capital but profits shall be shared in the agreed ratio determined beforehand.

The principle of mudarba as a basis of financial intermediation in the Islamic economy is offered as a viable alternative of interest-free banking system. The creditor docs not cam interest on a fixed rate in this system, but participates in the business risk and cams a share of profit. Thus, under Islamic banking system, the cost of capital is not zero as some people wrongly assume it to be analogous to zero interest rate. The only difference between the Islamic banking and interest- based banking in this respect is that cost of capital in the interest-based banking is expressed in terms of a predetermined fixed rate while in Islamic banking, it is expressed as a ratio of profit. Some writers have even suggested that profit-sharing ratio in an Islamic economy could discharge the same functions which are performed by the interest rate in a capitalist economy. Thus profit-sharing ratio could work as an allocative device as well as a control variable.


Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Repulished with permission.