What is Islamic banking?

Islamic banking is banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. A banking system that is based on the principles of Islamic law (also known Shariah) and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. Collecting interest is not permitted under Islamic law. The Dubai Islamic Bank has the distinction of being the world's first full-fledged Islamic bank, formed in 1975.300 institutions spread over 51 countries as well as an additional 250 mutual funds. In 1983, Bangladesh established its first Islamic bank. 11 Local & Foreign owned; Profit Oriented & Shariah based Islamic Banks working in Bangladesh. Deposit Mobilization Techniques Al-Wadiah Current Deposit Account Al-Wadiah implies that the bank receives fund with undertaking to refund the deposit on demand and also with authorization from the depositors to use the fund for benefit of and at the risk of the bank. Islamic banks do not pay profit on this deposit. Mudaraba Savings Deposit Account It is totally different from the savings account of the interest based banks. Mudaraba principle implies that the bank receives deposits from the depositor with the authority that the bank will have exclusive right to manage the fund and

the profit resulting . In the case of Mudaraba deposits, the depositor is the Shahib-al-Maal and the bank is the Mudarib. Term Mudaraba Deposit Account Islamic banks receive term deposit for a minimum period of 3 months to 3 years on the principles of Mudaraba. Bank invests the money, earns profit, and shares it with the depositor as per predetermined Mudaraba ratio agreed upon at the time of the contract. In case of loss, depositors bear the loss in proportion to their deposits at their accounts. Special Mudaraba Deposit Accounts When an Islamic Bank receives Mudaraba deposits for investment in some business sector, or project, the deposit is called special Mudaraba deposits. In this case, an Islamic bank, while receiving deposits, comes to an agreement with the depositors that money to be received will be invested in some specific business ventures like fertilizer or salt business; or in some specific sectors like industrial , textile , export-import sector etc. or some specific investment sector of the bank like real estate, ship breaking or shipping project etc.

Fund Utilization Techniques Profit Sharing Principle : Mudaraba (short term) : Profit sharing principle for Islamic business contracts is based on the Mudaraba principle in which the owner

of the capital or entrepreneur for some business or productive activity on the condition that profits generated will be shared between them. Profit and Loss Sharing Musharaka (long-term): Musharaka is a form of business organization where two or more persons contribute to the financing as well as the management of the business, in equal or unequal proportions. Profits may be divided in any ratio agreed upon between the partners because the two parties may share the work of managing the business or project in any amount mutually agreed upon. Output Sharing output is shared between the parties in contract. Output sharing contracts are mainly of two types namely, Muzaraa and Musaqat. Muzaraa is a contract between an owner of a piece of agricultural land and a farmer for farming it in return of a percentage of its crop. In case of bank, bank provides farmers land for cultivation on crop sharing. Musaqat is one of the variants of Muzaraa. In this case, bank provides farmers orchards, gardens or trees for harvesting on crop sharing. Mark-Up Principle This is a cost plus contracts in which one party wishing to purchase equipment and commodities approaches the other party to purchase those items and sell to him at cost plus a declared profit. Farmers may also get various inputs and agricultural implements from the bank on a deferred payment basis. Lease Principle

An individual short of funds may approach another with a surplus to fund the purchase of a productive asset and renting that to him on rent-payment basis. lessee becomes the owner of the asset, then it will be called Hire Purchase or Ijara wa Iqtina. Advance Purchase In case of advance purchase in Islamic banking, two types to process are Bai-Salam The term Bai-Salam means advance payment or forward buying. The Salam contract is the sale of a good to be delivered to the purchaser at a future date, which is set at the time of the contract. Bai-Istisnaa Bai-Istisnaa is a contract of acquisition of goods by specification or order where the price is paid progressively in accordance with the progress of a job. An example would be for the purchase of a house to be constructed, payments are made to the developer or builder according to the stage of work completed.

Challenges of Islamic Banking Absence of an organized Islamic inter-bank money market Absence of full-fledged legal framework for Islamic banking Shortage of trained and efficient manpower committed to Islamic banking Lack of co-ordination and co-operation among the Islamic banks Lack of Shariah-compatible regulatory and supervisory standards

Inappropriate organization of the Shariah Councils and weak follow-up of the Shariah implementation status of the Islamic banks Lack of corporate governance in the Islamic banks

Some of the most important challenges facing the Islamic banking industry are identified as follows. Legal Support: Islamic law offers its own framework for execution of commercial and financial contracts and transactions. Nevertheless, commercial banking and company laws appropriate for implementation of Islamic banking and financial contracts do not exist. The legal framework of Islamic banking and finances might include the following: a. Islamic banking courts: The disputed cases of the Islamic banks are subject to the same legal system and are dealt with the same court and judge as the conventional one while the nature of the legal system of Islam is totally different. To ensure a proper, speedy and supporting Islamic legal system, amendments in existing laws, which are repugnant to injunctions of Islam, are required to promulgate Shariah compliant law for resolution of disputes through special courts.

b. Amendment of existing laws: Islamic banking has some kind of resemblance to universal banking, therefore, laws and regulations have to be amended accordingly to accommodate this new concept

c. Islamic banking law: In the absence of Islamic banking laws, the enforcement of agreements in courts may require extra efforts and costs. Therefore, banking and companies laws in several countries require suitable modifications to provide a level playing field for Islamic banks.

d. Islamic banking balance sheet: Islamic banks do not show assets financed through Ijara, Murabah etc. all the assets owned by Islamic banks be mentioned in their balance sheets.

e. Monthly payment agreement: The housing finance is executed on the basis of Diminishing Musharaka by the Islamic banks. Under this mode the house is jointly owned by the bank and the customer. The bank rents out its share to the customer on Ijara basis. The Islamic bank while executing Ijara with the partner/customer, uses the term Monthly Payment Agreement instead of having the Ijara agreement with the customer.

f. PLS deposits: Deposits in Islamic banks are usually based on principle of profit and loss. If something happens and the bank suffers loss it has to be transferred to the depositor directly.

Islamic prudential regulations: At present, lack of effective prudential regulation is one of the weaknesses of the Islamic banking industry. some of the Islamic banks are using the term of security, hence making the Ijara contract non-Shariah compliant as using the deposited sum under the heading of Ijara security (Rahn) is nothing but Riba which is strictly prohibited by Islam. Moreover, Ijara financing is subject to compulsory insurance which is essentially prohibited. Risks: The nature of risk in Islamic banking is different from those of conventional banking and therefore some special prudential, accounting and auditing standards should be applied to them. Shariah based product: All Islamic financial institutions offer the same basic products, but the problem is that each institution has its own group of Islamic scholars on the Shariah board to approve the product.Consequently, the very same product may have different features and will be subject to different kind of rules in these institutions. Nature of Islamic banking: Islamic banks are offering only Murabaha and Ijarah whileleaving the core and difference making Islamic financial instruments such as Musharakah and Murabah. It is necessary to enhance and facilitate the implementation of real Islamic banking activities i.e. promoting risk sharing

through equity type facilities on the asset side and profit sharing investment accounts on the funding side. Islamic future exchange: In conventional system, the most important source of these long-term investments are investment banks, mutual funds, insurance companies and pension funds. Islamic banks do not deal with interest bearing bonds. Therefore, their need for equity markets is much higher. On the top of it, the most of the products in Islamic banks are based on goods and commodities while prices and currency rates go up and down frequently, creating a big risk for them being traders in reality especially in the case of Salam and Istisna'a. To hedge the risk, they are in need of derivative products and consequently of Future Exchanges.