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Principles of the Islamic Banking System


Many of the old and the wise-men discussed in Part 4 and Part 5 of this series, have influenced and reminded contemporary scholars about the dangers that are inherent in the private banking system.

Well-known scholars thus far have understood that the private banking system is the root cause of the perpetuating debt and unsustainable growth that many countries have been experiencing.

These problems have forced many leaders to propose solutions to the current monetary system.

This movement is known as Monetary Reform, and within the movement there are quite a few different camps. These include;

Fiat Debt-Free Money Reformers (FDF)

Modern Money Theorists (MMT)

Post Keynesian Reformers (PKR)

Islamic Banking Advocates (IBA)

Social Credit Reformers (SCR)

Land Reformers (LR)

Hard Money Reformers (HM)

Competing Currency Reformers (CCR)

This article presents an in-depth analysis of the Islamic Banking System and discusses its fundamentals in order to understand why Islamic banks fared quite well as opposed to those in western democracies.

To understand the Islamic Banking Model, one must first understand Sharia Law, which dictates the manner in which Islamic banks should operate in the economy.

Islamic Banking and Sharia Law


Sharia law symbolizes the religious law and moral code of Islam, and it dictates policies on law, crime, politics, and economics.  For the purposes of this article we will be examining the economic aspect of Sharia Law.

Sharia Law is determined from two primary Islamic sources; the precepts set in the Qur’an and the example set by Prophet Muhammad.

Both the Qur’an and the teachings of Prophet Muhammad outline the activities which are considered acceptable (Halal) and forbidden (Haraam).

Actions that are Haraam under Sharia Law are,

  • Riba: The charging of interest
  • Haraam: Activities which contradict Sharia Law



In Islam, the term Riba is often associated with usury and the charging of interest, both of which are declared haraam in Islam.

Under Sharia Law, Islamic banks are prohibited from charging interest on the money that they loan out to borrowers. This is because any form of making money through lending money is forbidden.

The Qur’an (Koran) explicitly states that usury is forbidden in Verse 278, where it reveals,

O You who believe! Fear Allah and waive what is still due to you from usury if you are indeed believers; [278] or war shall be declared against you by Allah and His Messenger.

As noted above, the Qur’an explicitly prohibits Riba, and since the Qur’an is an undisputed source of guidance in Islamic countries, this ensures the unanimous agreement by all Islamic banks on prohibition of Riba.

In addition, Prophet Mohammad (Peace Be upon Him), said in his farewell sermon,

God has forbidden you to take Riba; therefore all Riba obligations shall henceforth be waived. Your capital, however, is yours to keep. You will neither inflict nor suffer inequity.

Muhammad’s teachings serve to remind Islamic banks that their obligation is not to inflict inequity but rather to promote equity amongst the public by offering loans without Riba.


Haraam (Forbidden Activities)

In addition to Riba, Islamic banks are also restricted from engaging in haraam transactions.

Such transactions include investing in alcoholic, pork, or gambling ventures.

The goal of these restrictions has historically been to steer Islamic banks towards engaging in ethical investments and moral financing.

The Islamic banking systems adherence to Sharia Law is precisely the reason they avoided engaging in transactions involving risky derivatives, and toxic assets.

In contrast to the Islamic banking system, the Conventional banking system has no incentive to engage in such ethical investment. Thus, conventional banks have engaged in speculative risky derivatives.

Unethical and immoral transactions are prime contributors to the global financial meltdown of 2008, when many conventional banks suffered an extreme loss of liquidity leading to insolvency issues.

Islamic banks have continued to maintain stability in the wake of the financial crisis.

This stability is due to how Islamic banks operate in comparison to conventional banks.


Islamic Banks (IB) vs. Conventional Banks (CB)


The foundation Islamic banks rest on is asset-based (full reserve), and emphasizes risk sharing.

In contrast, Conventional banks rest on a debt-based (fractional reserve) system and emphasize in risk transferring.

Conventional banks also charge interest on loans and do so because it represents the opportunity cost of lending out their money.

Thus, conventional banks take advantage of the borrower through the charging of interest.

Islamic banks are not permitted to charge interest on the capital they loan out. The reason for this is clear, interest can take advantage of the borrower and under religious law, the borrower must never pay more than the principal amount given as a loan.

In addition, Islamic banks are not allowed to earn profits without undertaking risks.

The analogy of labor serves as a perfect illustration of this. Only when a person produces something of value do they get paid.

Similarly, only when an Islamic bank engages in a risk that benefits society,  can it have any right to profit from that loan.

Both Islamic and Conventional banks aim to maximize profits for their shareholders, however, Islamic banks are restricted by the provisions in Sharia law.

Islamic banks have a vested goal in improving, and ensuring growth of the borrower, since the borrower’s success is their success. Thus, Islamic banks form partnerships with their borrowers and one that emphasizes greater equity.

This is best illustrated by using the example of an Islamic bank and an entrepreneur.

The Islamic bank wants to ensure the entrepreneur’s success since its profits are contingent upon it.

CB: Conventional banks however, have no such inclination, acting merely as facilitators of loans and deposits. The relationship between the bank and the borrower is strictly creditor to debtor.

IB: The relationship between the bank and the borrower implies one of a partnership where both parties share profits and losses equally.

This relationship is important because it is one of the fundamental ways that Islamic banks earn profits without Riba.

The absence of Riba makes it very difficult for Islamic banks to achieve profits without alternative methods of financing.

Thus the Islamic banking system has evolved to provide several different methods of financing, which are addressed in further detail below.


Mechanics of the Islamic Banking System

The Islamic Banking system operates on the methods of financing;

  • Musharakah (Joint Venture)
  • Mudarabah (Profit Sharing)
  • Murabahah (Cost Plus Sale)
  • Ijarah (Lease)
  • Qard Hassan (Good Loan)
  • Wadiah (Safekeeping)
  • Hibah (Gift)

Each of these is discussed in-depth below.


1. Musharakah (Joint Venture)

Musharakah is an agreement between the Islamic bank and its partner, whereby each partner provides funds to be used in a venture. The profits that are generated are shared between the partners according to the invested capital.

Musharakah is considered halal (acceptable) under Sharia Law because Islamic banks share the risks with their partner in the case of a loss.  The underlying principle is that if there was no risk involved in the venture, then there should be no reward.


2. Mudarabah (Profit Sharing)

Mudarabah is a contract, where Islamic banks provide capital to another party in order for them to invest in a commercial enterprise. Any profits generated as a result of the investment are generally determined by pre-agreed conditions. In contrast to Musharakah, under profit sharing, only Islamic banks may incur a loss.


3. Murabahah (Cost Plus Sale)

Murabahah refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchasing and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin.

This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled.


4. Ijarah (Lease)

Ijarah refers to the lease of assets and equipment such as office equipment and motor vehicles. Under Ijarah, the Bank rents assets to the customer, for a fixed period and price.


5. Qard Hassan (Good Loan)

Qard Hassan is a loan extended on a goodwill basis. Under a ‘good loan’, the borrower is only required to repay the amount borrowed.

However, the borrower may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the Islamic bank. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Since Qard Hassan operates as a true interest-free loan, it is fully compliant with Sharia law.


6. Wadiah (Safekeeping)

Wadiah refers to the practice of safeguarding deposits. When a depositor places funds into the bank, the bank guarantees to repay the depositor the amount of the deposit whenever it is demanded to do so. This is essentially a form of Full Reserve banking that is postulated by Austrian school scholars and economist Stephen Zarlenga.


7. Hibah (Gift)

Hibah is a voluntary gift given by an Islamic bank to a depositor in return for a loan. Banks reward depositors with Hibah as a ‘Thank You’ for permitting them to use the money in their savings account.

Banks usually offer better rewards to entice depositors to place more of their savings in the bank, thus providing the bank with capital necessary to create its profits. If these ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.


Thus, as noted above, the 7 functions of the Islamic bank system work together to create a system free of Riba (Usury).

A number of Islamic scholars and academics praise the functions of the Islamic banking model as an effective panacea to cure the monetary system from Riba (interest).

These scholars go on to argue that the Islamic banking model is superior to the model of Conventional banks, and is the way forward to monetary reform.


Advocates of the Islamic Model

Indian Economist Najatullah Siddiqui has been one of the foremost advocates of the Islamic Banking model.

Siddiqui strongly believes that Islamic banks have a comparative advantage over Conventional banks.

Siddiqui highlighted three of these advantages in his article titled; Comparative Advantages of Islamic Banking and Finance, where he writes,

1. Islamic finance forges a closer link between real economic activity that creates value and financial activity that facilitates it.

2. Islamic finance does not allow creating new risks to profit thereby.

3. Islamic finance is global and cosmopolitan.

Siddiqui argues that these three advantages helped to strengthen Islamic banks, because they were less vulnerable to gambling and had a closer connection to the real economy, thus giving them greater stability relative to conventional banks.

Siddiqui also argues that Islamic banks were open to any innovations that are in congruence with its fundamentals because it had an open system, and did not discriminate transactions with regional, ethnic, or class affiliations.

Economist, Iraj Toutouchian, also points out the benefits of the Islamic banking model, in supporting the Capitalist system of the Western countries.

Toutouchian states that the Islamic banking model is the only way to prevent the collapse of the Capitalist system of the West.

Toutouchian presents the case for Islamic banks in his paper titled Islamic Banking: A last Ditch to Save Capitalism, where he writes,

The capitalistic economy is fraught with many problems…

A: One of the conditions to attain sustained growth (development) is the equitable distribution of income and wealth. It has been demonstrated (by Westerners) that capitalistic economy will not reach such equity.

B: The capitalistic economy is faced with a conflict between efficiency and equity. This, among others, makes one of the fallacies of capitalism. Whereas, in Islamic economics there is no goal higher than establishing justice and fairness. We should be able to demonstrate that through implementation of the Diving Rules of Islam, by which efficiency is attained, we can also reach equity. Islamic banking will accelerate this goal.

Toutouchian later adds,

Having banned interest (Riba), and having logically eliminated money market, speculation and all related affairs in secondary market, which involve artificial risks, Islam attempts to emancipate all [persons] (Muslim and non-Muslim) from being dominated by wealthy individuals who have always lived a life exploiting others…By the omission of interest from the whole system, money whirlpool will disappear and thus the necessary condition for full employment (that is, the equality of saving with investment) will be created.

Islamic scholar Abdul Gafoor concurs with the view of the above economists on the relative benefits of the Islamic banking model.

Gafoor pays particular praise to the Musharakah (joint venture) principle of Islamic banks, in his book titled Interest-Free Commercial Banking, where he writes,

Participatory financing [Musharakah] is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.

Thus as clearly noted, the above scholars and academics all outline the benefits of the Islamic Banking system on the abolishment of Riba, and the advantages of the system over conventional banks

However, several critics argue that the benefits of the Islamic banking model are not as rosy as that pictured by the advocates.


Critics of the Islamic Model

One of the most ardent opponents of the Islamic banking model includes economist Shah Abdul Hannan.

Hannan argues that the Islamic banking system is unrefined, due to the confusion resulting from different views on the concept of Riba and the methods of financing employed by Islamic banks.

Hannan outlines his arguments in his article titled Islamic Banking: Problems and Prospects, where he writes,

A major issue here is that, it is the Sharia Councils or Boards at individual Islamic banks that actually define what is and what is not Islamic banking, and what is and what is not the acceptable way to do business, which in turn can complicate assessment of risk for both the bank and its customer. More generally, the uncertainty over what is, or is not, an Islamic product has so far prevented standardization. This is difficult for regulators as they like to know exactly what it is they are authorising. It is also an added burden on the banks that have to educate customers in new markets.

Hannan argues that the standardization of Islamic banking practices is necessary in order to refine the Islamic banking system and help enable smoother transactions between Islamic banks and their partners.

The Founder of the World Islamic Mint of Malaysia, Umar Vadillo, also criticizes Murabaha on the grounds that it combines two transactions into one.

Vadillo expresses his arguments in his book titled: Fatwa on Banking and the Use of Interest Received on Bank Deposits, where he writes,

Murabaha occupies between 80 to 90 percent of all Islamic Banking transactions. We could say that without their version of Murabaha, Islamic Banks would not be able to exist today. Under the label of Murabaha, which is a sale, Islamic Banks portray a means of finance based on a well-known forbidden practice known as “two sales in one”. This practice of “two sales in one” is a disguising mechanism which presents usury as if it was profit.

Imran Nazar Hosein also attacks the Islamic practice of Murabahah, in a video interview titled: Islamic Banking a Form of Oppression, where he says,

When you buy and are given the time to pay, this is called a credit transaction. So a credit transaction is halal in Islam. … If [the] credit price is higher than [the] cash price, higher purchase, or Murabaha, the difference between the two would be because of time…If you believe that money can increase over time you are misguided, dangerously misguided, because Allah says “No”. Money cannot increase over time. That transaction is invalid, that is Riba. But the Islamic banks’ so called Murabahah, is not halal at all, it is actually Riba through the back door.

Critics also attack the Islamic banking model on the practice of Ijarah (renting) assets and equipment.

Ijarah is used by many Islamic Banks such as the Islam Bank in Bangladesh, to provide loans to borrowers with an additional fee referred to as the profit margin.

Islamic banks argue that the fee complies with Sharia law since the amount of money is fixed and unchanging, unlike the compounded interest charged by Conventional banks.

Critics argue that this is a form of simple interest where banks gain a fixed rate of return simply from extending a loan which is haraam.

The Islamic banking model serves to illustrate the strict rules and regulations that banks are expected to abide by.

The next article presents the proposals advocated by Social credit reformers who argue that there needs to be significant banking reform conducted in order to support the welfare of all people.


Part 1 – The Overview of Canada’s Current Financial Position

Part 2 – How the Monetary System Works

Part 3 – The History of the Bank of Canada

Part 4 – The Dangers of Usury in the Banking System

Part 5 – The Dangers of Usury in the Banking System Pt 2

Part 6 – The Loss of Canadian Sovereignty

Part 7 – The Decline of Canada’s Economic Environment

Part 8 – The Movement for Monetary Reform

Part 9 – A Review of the Fiat Money System

Part 10 – The Fundamentals of Modern Money Theory

Part 11 – Endogenous Theories on Monetary Reform

Part 13 – A Review of the Social Credit Money System

Part 14 – Henry George and the Land Reform Movement

Part 15 – A Review of the Austrian School of Economics and the Gold Standard

Part 16 – Currency Competition and Alternative Money Systems

Part 17 – The Shadow Banking System

Part 18 – Economic Recovery at the End of the Road


Comments (5)

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