Defining Islamic Banking

During the early years of Islamic banking between the 1960s and 1980s, the main focus of these banks is to establish Islamic working framework within their national boundaries. There is no significant issue then that requires international attention. It is only until the creation of the inter-governmental Islamic Development Bank in 1994 that expanded Islamic finance internationally, a new banking system inspired by Islam religion principles. Today, there are more than 250 financial institutions with Islamic banking operations worldwide.

The fundamental of Islamic finance industry is where its operations need to comply with Syariah principles. There is an underlying Syariah compliant contract for every financial product offered by these institutions. Due to the fact that Islam does not recognise the separation between spiritual and material affairs, Syariah principles throws conventional banking framework out of perspective.

An example is the perception of customer for a bank. Islamic banking looks at the customer as an equity provider without voting rights whereas conventional banking sees customers as liabilities. Another example is how the banks recognize their income. In conventional banking, income recognition is based on accruals concept but under Syariah principles, income is recognized on cash basis.

Currently, the main differences between Islamic banking and conventional banking are as follows:-

  • In the conventional “world”, any transaction is presented according to their substance and economic reality, not just the legal form. “Substance Over Form” violates Syariah principles as it places great importance on contractual agreement, being the foundation of determining the rights and obligations of the parties to the contract.
  • Prudence concept in conventional accounting promotes cautiousness by way of recognising in the financial statements, foreseeable expenses before they happen and ignoring unconfirmed income. This contradicts the Syariah principle of “fair reporting” that would reveal halal (“legitimate”) and haram (“forbidden”) transactions, which in turn means unfairly concealing information to the stakeholders.
  • While the simplest basis to measure the value of an asset is to record its historical cost, another consideration is the probability of future economic benefit that is associated with the asset that will flow into the organization, hence fair value. Islamic banks’ asset valuation is also similar but the influence criteria will be within the terms of the Syariah contract underlying the financial product. The main issue for consideration is whether the customer’s promise to purchase the asset is a binding. If the promise is binding, the asset can be valued at historical cost. If the promise is non-binding, which means the bank is taking the risk of loss, the asset will be valued at cash equivalent if sold in the market.

Even though on the surface, an Islamic bank offers similar range of products as found in conventional banks such as leasing, mortgages, trade lines etc, the legal structures of these contracts are Syariah compliant. Some of the Islamic banking product definitions:-

  • Murabahah refers to assets purchase financing. It is where the sale of goods is at cost, plus an agreed profit mark up. Further, the seller must inform the purchaser of the capital outlay and terms for the product, and quantify the bank’s profit from this transaction. It also prohibits exploitation by the bank on the customer by having unfair contractual terms.
  • Istisna’a refers to project financing, whereby the sale contract of an asset that is required to be manufactured or constructed before delivery. Due to the possible uncertainty of future events, the bank will enter into 2 separate contracts. At the start, the Islamic bank will accept an order from a customer wishing to acquire a “future” asset. The bank, at the parallel time, enters into another set of Istisna’a contract with the developer of the “future” asset. There are however, 2 interesting conditions that need to highlight here. First is the performance of one contract cannot be made conditional on the other Istisna’ contract. Secondly, specification of the asset must be strictly adhered to.
  • Ijarah refers to a contract similar to leasing in conventional banking. It is a contract of utilising the benefits of an asset for a rental consideration. Conditions of an Ijarah contract include the existence of a valid lessor, lessee, the identified asset and its benefit, rental consideration and lastly, a valid offer and acceptance of the contract. Since Syariah does not recognise substance over form, Islamic banks will need to record these assets within their books, whereby conventional banks do not since risk and reward of the assets had already changed hands to the lessee.
  • Mudarabah is a partnership contract between a capital provider and an entrepreneur. The Islamic bank, also known as the capital provider will need to provide the full amount of capital upfront to the entrepreneur. The entrepreneur can utilise the capital for his business activities whereby the business provides expertise, manpower and management. Profits made will be shared between the partners at a pre-agreed ratio. In case of loss, the bank will lose its capital.
  • Musharakah is an agreement whereby the customer and the Islamic bank agree to combine their financial resources to undertake a business venture, with the contractual terms specifically spells out the profit (or loss) sharing ratio between the partners.