Demystifying the concept of Islamic banking
The Islamic banking system is gaining popularity in Malaysia, and is considered to be on par with conventional banking.
Many people don’t know that Islamic banking is also open to non-Muslims, and offers additional benefits such as certainty with your loan repayments and no late interest charges.
By Zuhaidi Shahari
Islamic banking and finance is a provision of financial services that is compliant with the principles and rules of Syariah law. This system of banking emerged as a new entity in the global financial market in the 1970s. Its philosophies and principles are, however, not new, having been outlined in the Holy Qur’an and the Sunnah of the Prophet Muhammad more than 1,400 years ago. Islamic banking in modern times aims to promote and develop the application of Islamic principles, law and traditions to financial, banking and related business transactions.
The underlying principles that govern Islamic banking are mutual risk-taking and profit-sharing between parties, the assurance of fairness for all, and that transactions are based on an underlying business activity or asset. These principles are supported by Islamic banking’s core values, whereby activities that cultivate entrepreneurship, trade and commerce, and bring societal development or benefit are encouraged. Furthermore, activities that involve interest, gambling and speculative trading are prohibited.
Regulated for safety
So what is Islamic banking? Islamic banking is a banking activity which is consistent with Islamic law (Syariah). Islamic banking is carried out in accordance with Islamic transaction rules. In Malaysia, the Islamic banking system is governed by the Islamic Financial Services Act 2013 (IFSA), which supersedes the Islamic Banking Act 1983 and the Takaful Act 1984, and took effect on 30 June 2013. The Act provides for the regulation and supervision of Islamic financial institutions, payment systems and other relevant entities. It also oversees the Islamic money market and Islamic foreign exchange market, to promote financial stability and compliance with Syariah law and for related, consequential or incidental matters.
Islamic banks, like conventional banks, are profitable organisations. Their aim is to be profitable, but they are not allowed to deal in interest-based business models or engage in any business or trade prohibited by Islam. The major difference between the two systems is that in the conventional system, the banker-customer relationship is a debtor-creditor relationship with a guarantee of repayment and a fixed percentage return.
The conventional banks’ profitability depends greatly on the margin between the borrowing and the lending rate. On the other hand, Islamic banks are governed by Syariah rules that prohibit interest-based transactions. The banker-customer relationship can take a different form based on the contracts entered into by the Islamic bank and the customer.
Islamic banks will make a profit from business transactions entered into with its customers, whether it is a sale, lease, investment, partnership, or other type of transaction. In this instance, the return will be shared between the two parties, based on a certain ratio or percentage agreed upon in advance.
Advantages aplenty
The Islamic banking system has a few advantages over the conventional banking system. The conventional banking system is almost totally based on interest-based lending, while the element of interest is prohibited in the Islamic banking system. In conventional banking, there is the concept of late interest charges. In Islamic banking, however, the bank can only charge compensation on late payment on the principal amount due, and this compensation is not compounded.
Secondly, conventional banks will charge a prepayment penalty, but no penalty on prepayment is charged in Islamic banking. There is an element of uncertainty in the conventional banking system that does not exist in Islamic banking as the profit is fixed and certain. The rationale for this is that in conventional loans, the transaction is based on the Base Lending Rate, while Islamic loans are based on the Base Financing Rate, whereby the bank can actually adjust the base rate based on prevailing market conditions. But this is subject to the ceiling rate, which is the maximum profit an Islamic finance provider will earn.
From the clients’ perspective, the banking system in Malaysia offers both options; the public can either opt for conventional banking or Islamic banking. In fact, the Islamic banking system is not exclusive to Muslims only. That has always been the case from the time Islamic banking was introduced to Malaysia. It is not a question of faith or religion, but of choosing a system that offers additional benefits to customers.
Of course, it is to your advantage that the banking system gives you certainty about your repayments as opposed to a floating interest system, and also removes arbitrary penalty charges. This is only possible as Islamic financing instruments cannot be based on the concept of money-lending or deposit-taking. As mentioned earlier, it must be transaction based, be it sale, leasing, partnership or investment.
Varied products
Meanwhile, more sophisticated products have been developed to cover areas such as derivatives, commodities trading, treasury and the money market. We must also highlight that these Islamic finance products must be approved by certified Islamic scholars to ensure strict compliance with Islamic principles, and are not merely new names for existing conventional financial products.
In conclusion, the Islamic banking system is gaining popularity in Malaysian society, and stands alongside the conventional banking system. Although it is comparatively new, Islamic banking has the potential to develop into a more comprehensive banking system in future.
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