Under the Islamic banking system, all their objectives and operations are based on focal Sharia’a principles. However, there are several key principles of Islamic Banking, among which is riba (interest), gharar (uncertainty) and maysir (gambling). It is revealed in Quran (Al-Baqarah, 2:275) “Allah has permitted trade and has forbidden riba“. Riba refers to any predetermined payment above the actual amount of the loan principal. Thus, an Islamic bank is a deposit-taking banking institution whose scope of activities includes all currently known banking activities as indicated in the introduction, which excludes borrowing and lending on the basis of interest.
The profit and loss sharing principle is considered extremely vital in Islamic Banking, it encourages Muslims to invest their money and become partners in a business instead of becoming creditors. Consequently “the depositor, the bank and the borrower all share the risks and rewards of financing a business venture”. On the assets side, it advances funds on a profit-and–loss sharing or a debt-creating basis, in accordance with the principles of the Sharīah. It plays the role of an investment manager for the owners of time deposits, usually called investment deposits. On the liabilities side, it mobilizes funds on the basis of a Mudarabah contract, which I will discuss in detail later.
In addition, equity holding as well as commodity and asset trading constitute an integral part of Islamic banking operations. An Islamic bank shares its net earnings with its depositors in a way that depends on the size and date-to-maturity of each deposit. Depositors are usually given prior information of the formula used for sharing the net earnings with the bank.
Another future of an Islamic Bank is that all financial transactions should be asset-backed; meaning that “making money out of money” is prohibited. Money in Islam is considered a medium of exchange that represents the purchasing power of individuals and has no value on itself. Hence, most argue that, it only becomes capital generating when it is invested in a productive business. Islamic banks can also accept demand deposits, which are treated as interest-free loans from the clients to the bank with guarantee.