Islamic Banking Concepts
  • 31 Jan 2024
  • 7 Minutes To Read
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Islamic Banking Concepts

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Article Summary

Islamic banking products are made up of contracts based on Shari'ah Law. The principles of Islam, expressed by Shari'ah Law, provide the foundation and the contracts built on these principles provide the structure for financial products.

Principles

The basic principles that all Shari'ah-compliant products adhere to are:

  1. Profit or Loss Sharing: Financial contracts ensure the equitable sharing of profits or losses among participants.
  2. Prohibition of Interest: Charging, collecting, or paying interest within financial contracts is strictly prohibited.
  3. Avoidance of Haram Transactions: Transactions involving forbidden (haram) products are strictly forbidden.

Contracts

The contracts that provide the structure for financial products can be used interchangeably depending on their terms. It is important to note that contracts can be found to be contravening Shari'ah principles, despite being used in practice for a certain time period. For example, the Sukuk contract - an analog for bonds - has attracted criticism from regulators in recent years and has resulted in a decline in use and popularity.

Warning!

It is incumbent on you as a financial product developer to ensure that the contract you base your products on is valid according to Shari'ah principles and current law.

Mudarabah

Suitable for Mambu product types: Deposits

A party deposits their funds with a counterparty, which is tasked with managing those funds for a specified time period. Profits from this arrangement are shared between the parties. The return that the depositor gets is determined by the deposit amount and time period that the funds are managed by counterparty. Importantly, losses can only be levied on the depositor - unless there is negligence or misconduct on the part of the counterparty.

Please note

Banks often use this contract in conjunction with another Mudarabah, where the fund management is outsourced to an investment manager. Further distinctions can also be made with a Mudarabah that is restricted to investing only in certain assets or businesses.

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Example
Ali from Qatar is looking to deposit QAR 100 for 24 months and is hoping to get back QAR 105 (or more) back at the end of that period. He shops around for a contract and finds that the Qatari Infinity Bank offers a Mudharabah that gives 10% of profits to the depositor and takes 90% for managing depositors money.

Ali agrees to this contract and deposits his money with Infinity Bank. The bank takes the deposit and puts it into an investment pool with other depositors. After the two year period the pool returns an 8% profit on the original investment.

Ali's portion of the investment pool is QAR 108, but the contract stipulated that 30% of the profit (QAR 8) goes to his partner for services provided. So, the bank gets QAR 2.40 and Ali gets QAR 5.60 - leaving him happy with a total of QAR105.6.

Wakala

Suitable for Mambu product types: Deposits

Wakala is similar to Mudarabah, except for some key differences. A party deposits their fund with a counterparty, which operates as the representative of the depositor to carry out their investment according to instructions. This principal-agent relationship is a key distinction.

The other key distinction is that the counterparty promises an expected fixed return, and they also agree a cap for the maximum profit that the depositor may receive. Any profit in excess of the cap belongs to the representative and is an incentive for them to get as high a profit as they can.
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Example
Ali is an environmentally-conscious traveler who wants to save for a holiday and is looking for a savings account to make that trip possible. After reviewing a couple of Mudarabah-type contracts he finds the return he is likely to get to not be enough for his travel plans and finds that many of the banks invest in fossil fuel companies. He wants something more aggressive and is more likely to meet his needs, while not investing for the benefit of the environment (in addition to the principles of Shari'ah law).

From his research he finds Super Dubai Bank's offer, which although it is capped offers him more than the others. Super Dubai Bank offers a 12% return of up to AED70. The proposal from Ali to Super Dubai is to not invest his money in fossil fuel companies and he appoints them as his agent by taking out a savings account with them.

Some time later, Ali goes to the bank to withdraw his money from the savings account. He has saved a total of AED1000 and his savings have grown to AED1120. He expects the profit of AED100 to be split between him and his agent (the bank). But wait, the cap he agreed to is AED70 for his portion of the profit. This means that he will on get AED1070, as the remainder (AED50) goes to his bank as agreed earlier.
A Wadiah contract operates much like a safety deposit box. The depositor deposits their money or assets with the counterparty, who keeps the money and assets and guarantees to return them at a later date. Like a safety deposit box, you get back what you put in.

Wadiah

Suitable for Mambu product types: Deposits

A Wadiah contract operates much like a safety deposit box. The depositor deposits their money or assets with the counterparty, who keeps the money and assets and guarantees to return them at a later date. Like a safety deposit box, you get back what you put in.

In certain cases the counterparty may choose to share any profits derived from the arrangement. This gift is known as hiba and is entirely voluntary. The difference between Wadiah and Qard Hassan is that the counterparty acts as the custodian of the money or assets of the depositor, and the money and assets continue to be owned by the depositor.
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Example
Fatima wants to save some money for a gift for her friend later in the year, but knowing herself she expects that the money will be spent too soon. So she decides to get a simple deposit account to safekeeping the money for when her friend's birthday comes around. As she visits her bank's website, she notices that they offer this very service and she deposits 200 000 Rupees (Rs).

Her friend's birthday approaches and she happily withdraws the money to buy her friend a red cotton Kurta. Her friend is overjoyed to receive such a well-made item, but reminds Fatima that Pakistan Safe Bank often gives a small hiba and she should keep her money there next time so that they can both get a gift.

Qard Hassan

Suitable for Mambu product types: Deposits

Qard Hassan contracts operate much like Wadiah, bar this significant difference: the originator offers their deposit as a loan to the counterparty. The counterparty commits to repaying this loan in full back to the depositor. No profit or loss is shared between the participants of the contract.

This contract works both ways: the originator may be a normal depositor giving their money to a bank, and vice-versa, the originator may be the bank offering a loan to a client. In some cases, the counterparty may charge a fee for maintaining this arrangement.

Like a Wadiah contract, hiba may be offered to the depositor, where the depositor is the originator.

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Example
Muhammad finds himself in a bit of quandary. He is about to start a new job in London, but he does not have money to maintain himself until his first paycheck. He knows that he needs at last 500 Pounds (£) for the next month, so looks for a loan. Many Western banks offer him terms he can't pay back later, so he decides to look for a Qard Hassan arrangement.

At the London Islamic Bank he finds an equitable loan arrangement: the bank offers him a £450 loan that he will have to repay at the end of the month. While it's not everything he is able to make it through the month and pay back the Bank in full.

Tawarruq

Suitable for Mambu product types: Deposits

A Tawarruq contract is based on receiving or selling goods for deferred payment through a facilitator.

In a Tawarruq Deposit, an originator deposits an amount for a facilitator to purchase an asset on behalf of the originator. The facilitator, in their own capacity, then sells the asset on to an unrelated third party and returns the originator's deposit. The difference between the deposit the originator gives the facilitator to buy the asset and the selling price that the facilitator sells the asset for is what makes the profit that is shared between the originator and the participant.

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