Islamic Finance and Banking: An Overview for Every Muslim

islamic finance and banking

Today we are going to explore the evolution and impact of Islamic Banking and Finance. My aim is to provide every Muslim with insights from the IMF as well as an Introduction to Islamic Finance


Introduction to Islamic Finance and Banking

Islamic finance refers to a financial system that is based on Islamic law (Sharia) and guided by Islamic economics. The most well known feature of Islamic finance is the prohibition on interest (riba), but it also includes prohibitions on investing in prohibited industries and requires other forms of risk sharing.

Some key principles of Islamic finance include:

  • The prohibition of riba (interest)
  • The prohibition of gharar (excessive uncertainty)
  • Profit-and-loss sharing (PLS)
  • Asset-backing for transactions
  • Investments in ethical industries only
"At the heart of Islamic finance is an emphasis on partnership-style financing, the avoidance of interest, and the avoidance of finance of prohibited activities considered harmful to society." IMF

Islamic finance has roots in medieval Islamic commercial law, but grew rapidly starting in the 1960s. By 2022, global Islamic finance assets were estimated at $4 trillion, according to the ICD-Refinitiv Islamic Finance Development Indicator (IFDI) Report.

Some of the key participants in the Islamic finance industry include:

  • Islamic banks
  • Conventional banks with Islamic finance windows
  • Investment funds
  • Takaful (Islamic insurance) companies
  • Sukuk (Islamic bond) issuers

Today’s major hubs for Islamic finance include Malaysia, Bahrain, and the United Arab Emirates. But Islamic financial institutions now exist in over 50 countries.


Key Features of Islamic Banking

Islamic banking has several defining features that set it apart from conventional banking. This distinguishes Islamic finance from traditional banking heavily reliant on interest-based transactions.




Shariah-compliant refers to financial activities and transactions that adhere to Islamic law principles. The main guidelines prohibit interest (riba), speculation (gharar), and investments in specific industries like gambling, alcohol, tobacco, and adult entertainment. Islamic finance aims to promote fairness, ethical investments, and shared risk-reward.




Riba refers to interest or usury, which is prohibited in Islamic finance. Charging interest (such as on loans) is seen as exploitative and promoting inequality in society. Islamic financial institutions cannot charge or pay interest on money lent or borrowed. Instead, profit-sharing investment models like mudarabah and musharakah are used as alternatives.




Mudarabah is a profit-sharing partnership agreement between two or more parties – one provides the capital and the other manages the investment using their expertise. Profits are shared between them at a pre-agreed ratio, but the investor bears financial losses entirely unless negligence is proven against the manager. This aligns with Islamic principles of risk-sharing.




Musharakah is a joint venture or partnership agreement between two or more parties who contribute capital and share profits and losses. It encourages joint participation in a business or investment activity. The profit-sharing ratio is determined by the amount of capital contributed by each partner. This allows for pooling of resources and risks.




Murabaha is a cost-plus sale contract widely used for financing purchases. The financier purchases an asset and then sells it to the customer at cost plus an agreed profit margin. The customer pays in installments over time. It must involve actual buying and selling of assets so cannot be used for monetary loans.




Ijara is a leasing agreement that allows banks or financiers to purchase and lease equipment, property, or other assets to clients for rental payments over a specific period. Ownership of the asset remains with the lessor until leasing ends. The rentals are set to cover the cost and earn a profit margin.




Takaful refers to Islamic insurance which is based on mutual assistance and risk-sharing. Rather than transferring risk to the insurer, takaful pools contributions from participants into a fund which is used to support those needing assistance. Surpluses are distributed back to contributors. This aligns with Islamic finance principles.




Sukuk are Islamic financial certificates similar to bonds, representing ownership in an asset or enterprise. They provide fixed periodic payments to sukuk holders along with a share in the profits or losses. Sukuk represent proportional undivided ownership, avoiding conventional bonds’ prohibited “interest” aspect.




Zakat is the mandatory almsgiving in Islam – an obligation on Muslims meeting the minimum wealth criteria (nisab) to donate a fixed portion of their wealth to the poor and needy. It aims to redistribute wealth fairly and is one of the Five Pillars of Islam.


Halal investments


Halal investments refer to financial activities and assets that are permissible under Shariah principles. Industries prohibited include gambling, alcohol, pork, adult entertainment, tobacco, weapons, etc. Screening criteria are applied to filter out such sectors from investment portfolios.




Haram refers to any activities or investments that are prohibited in Islam such as riba (interest), gharar (excessive uncertainty), gambling, adult entertainment, alcohol, pork, etc. Islamic banks carefully avoid haram transactions to ensure Shariah compliance.


Qard Hasan


Qard Hasan are benevolent loans extended without interest or profit share. The borrower only pays back the principal amount. The lender does so for charitable reasons to support those in need. Islamic banks often use it for priority sectors like education, health, or SMEs.




Istisna is a sale contract where a manufacturer or builder agrees to produce specified goods and deliver them to the buyer on a given date for an agreed price. Payment can be made in installments. It allows financing of manufactured products.




Waqf refers to an Islamic endowment where a person donates an asset for religious, educational, or charitable purposes. The grants can be cash, property, shares giving regular income to benefit the community. It aims to promote social welfare.




Ujrah refers to fees, commissions or charges for services rendered in Islamic finance. Since guaranteed interest is not permitted, transactions often use ujrah as a service charge. Common examples include brokerages on purchases or management fees on investments.




Tawarruq involves monetization to provide cash financing based on a mark-up sale of a commodity. A bank purchases the commodity from a broker and sells it to the client at a markup providing immediate cash, which the client sells to get liquidity.




A fatwa is a non-binding legal opinion issued by an Islamic scholar on matters of Islamic law. Fatwas are given in response to questions submitted to a scholar or council. They pronounce permissibility or otherwise of matters like financial products, food, lifestyle issues as guidance.


Islamic window


Islamic windows refer to dedicated departments within conventional banks that offer Shariah-compliant products and services. This allows banks to provide options complying with Islamic finance rules while maintaining regular business.


Shariah board


The Shariah board, or the advisory committee, is a panel of Islamic scholars and jurists advising and overseeing financial institutions to ensure their products and services comply with Islamic principles. Approval from the Shariah board is critical for Islamic banks.




Nisab is the minimum amount of wealth required for a Muslim to be obliged to pay zakat. Only those with wealth above the defined nisab threshold need to pay the 2.5% annual zakat after accounting for living expenses and debts. The nisab amount varies for different asset classes.



    This adds an extra layer of ethical guidelines beyond conventional banking.




    Key Instruments and Contracts


    Islamic banks and financial institutions utilize a number of instruments and contracts to provide financial services in compliance with Sharia law:




    In a murabaha agreement, the bank purchases an asset for a client and then resells it to the client at a markup.


    "The bank steps into the purchase agreement between the client and the vendor, and buys the asset on behalf of the client before reselling it to the client at a profit." World Bank

    This allows the bank to earn a return without violating the interest prohibition.


    As noted earlier, mudaraba is a profit-sharing contract where one party provides the capital and the other provides labor/expertise. Profits are shared per an agreed ratio.


    Sukuk are Islamic financial certificates, similar to bonds in conventional finance. However, sukuk represent ownership stakes in an underlying asset.

    "Whereas bonds are debt obligations, sukuk certificates represent a proportional undivided ownership right in tangible assets or business ventures." IMF


    In an ijara agreement, the bank or financier purchases an asset for a customer and then leases it back to them. Ownership of the asset remains with the financier.


    Growth and Global Reach

    The Islamic finance industry has seen rapid growth over the last few decades. Some key facts:

    • Global Islamic financial assets are estimated at over $4 trillion as of 2022, which is almost 25% increase in 3 years.
    • More than 50 countries have Islamic financial institutions.
    • Major hubs include:
      • Malaysia
      • Bahrain
      • United Arab Emirates
    • Many conventional banks now offer Islamic banking services and products. For example:
      "Standard Chartered Saadiq has a global footprint across Asia, Africa, the Middle East, Europe and North America." - [Standard Chartered](
    • The sukuk market has grown substantially:
      "As of August 2021, cumulative global sukuk issuance exceeded $1.5 trillion." - [Boston Fed](

    However, the industry also faces some challenges:

    • Lack of standardization and regulation
    • Shortage of trained Sharia scholars to oversee compliance
    • Perception that Islamic finance is more expensive

    Overall, the outlook for continued growth is positive, driven by solid demand in Muslim-majority countries and growing interest from conventional institutions.



    In summary, Islamic finance is a rapidly growing segment of the global financial industry that operates according to Islamic law without interest, excessive uncertainty, and investments in prohibited industries.

    Key points:

    • The core principles are the prohibition of riba (interest) and gharar (excessive risk), as well as profit-and-loss sharing and asset-backing of all transactions.
    • Islamic banks utilize special instruments like murabaha, mudaraba, ijara, and sukuk to provide Sharia-compliant financing and investment.
    • The industry has expanded to over $2 trillion in assets across more than 50 countries, with major hubs in Malaysia, Bahrain, and the UAE.
    "Islamic finance has become systemically important in many regions and is poised to continue to grow rapidly over the next decade." IMF

    Despite some challenges around regulation and standardization, the future outlook remains strongly supported by demand in Muslim countries and growing interest from conventional finance. With increased global integration, Islamic finance is set to play an important role in the global financial system.

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