Islamic Banking Principles

There are six fundamental principles of Islamic banking. The first of these principles is the sanctity of contract. Prior to the execution of any transaction in the Islamic banking system, the parties involved have to ascertain that the transaction is valid (halal), in line with the Shariah law (Hasan 10). Secondly, there is the issue of risk sharing. In this case, parties involved in a banking transaction have to ensure that they do not earn any profit from capital or an asset unless the earner in question has already taken ownership risk for the capital or assets (Hasan 11). Thirdly, Islamic banks do not engage in interest (riba) related transactions. For example, Islamic banks are not allowed to lend money that will attract additional interest over and above the money that has been lent out.

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The fourth basic principle of Islamic banking is that every transaction carried out by an Islamic banking institution has a certain economic activity/purpose. Moreover, there must be real service or tangible asset backing up Islamic banking transactions. The fifth Islamic banking principle entails fairness. In this case, all Islamic banking institutions are called upon to instill fairness in all their operations (HSBC Amanah 3). As such, Islamic banks should not engage in dubious transactions. The final principle of Islamic banking is that Islamic banking transactions do not finance invalid activities or subject matters. For example, although certain activities or subject matters could be permissible under the law of the land, they may not actually be permissible under Shariah and as such Islamic banks cannot finance these activities or subject matters.

Islamic banks differ from traditional banks on a number of issues. For example, traditional banks are mainly concerned with mobilizing members’savings with the intention of channeling them to various social and economic issues. Traditional banks also extend credit to worthy borrowers in a bid to expand capital investments, increase production, and possibly attain a higher standard of living (Jobst 8). Some of the other services offered by traditional banks entail convenient methods of payment such as the use of credit cards and cheques, sale and purchase of securities, as well as the supply of foreign currencies (Jobst 9). Nonetheless, the ultimate goal is profit maximization dependent on a reasonable level of safety, sound performance, and liquidity.

On the other hand, Islamic banking institutions are mainly based on economic and philosophical principles. Since Islam represents a complete code of life, as such, financial and banking institutions should be guided by the fundamental teachings of Islam (Global Investment House 22). Therefore, Islamic banks do not operate under an interest rate mechanism. In addition, they also try to maximize objective functions such as social welfare and social benefit. Also, unlike traditional banks, Islamic banks utilize profit-sharing mechanism, as opposed to an interest rate mechanism.

Over the past three decades, Islamic banking has witnessed tremendous growth in the UAE. The country now has a dual banking system whereby Islamic banks operate side by side with the traditional banks. A study that was carried out by Oxford Business Group in partnerships with the Abu Dhabi Islamic Bank (ADIB) indicated that Islamic banks in the UAE represents 30 percent of the Islamic banking system in the world (Al Bawaba para. 2).

There has been a dramatic increase in demand for Islamic banking services in the UAE mainly because unlike the traditional banks, Islamic banks are faced with a less liquidity risk. They also depends less on external liabilities, in comparison with conventional banks. Traditional banks also have a higher volatility of profitability rations in comparison with Islamic banks (Jobst 15). For these reasons, Islamic banks have become very popular in the UAE and are now playing a crucial role in funding residential properties, infrastructure projects, as well as training and development of human capital.

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References

Al Bawaba. 2012. UAE Islamic Banks Account for 30% of Global Islamic Banking Industry. Web.

Global Investment House 2005, UAE Banking Sector. Web.

Hasan, Zubair 2005, Islamic banking at the crossroads: theory versus practice. Web.

HSBC Amanah. 2008. About Islamic Banking. Web.

Jobst, Andreas. The Economics of Islamic Finance and Securitization. Journal of Structured Finance, 13. 1(2007): 1-37.

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