Islam allows interest on financial transactions – neither for customers nor for the bank. This means that a savings account is as impossible as a loan that must be repaid-with interest. So in this case, how do Islamic banks profit?
In Islamic banks, investments are made in real commodities only, not in securities, stocks, or funds. The alcohol, tobacco, and pork industries are taboo. It also prohibits investing in arms deals and any deals of a gambling nature.
Financial experts see the existence of a large market for banking according to Islamic law.
How do Islamic banks make a profit?
Here the bank buys an asset on behalf of the customer and leases it to the same customer. Ownership of the asset remains with the bank, which is also responsible for its maintenance. The lease is concluded for a certain period and after this period (and the lease installments have been paid) the object is transferred to the customer.
Here the bank acts as an intermediary and buys an asset such as a car. This asset is then sold to the customer at cost plus known and agreed on profit. The customer pays the value in deferred payments.
The term wakala is used in Islamic finance to describe a contract of agency or delegated authority under which the muwakkil (the muwakkil) appoints an agent (the wakil) to perform a specific task on his behalf (the issuer). Here the bank acts as a single agent. The Bank provides its technical expertise and manages the investments of the client for a certain period on behalf of the client to achieve an agreed return.
The above points help the bank to generate income through Islamic banking services. Nowadays, more and more people are turning towards Islamic banking, and consumers all over the world appreciate the principles of Islamic banking.
Transactions in Islamic Banks
If the customer needs money to buy a house or a car, the Islamic bank buys the commodity for him, and then resells the property to the customer with an additional financing fee, and pays in installments.
Sometimes it becomes a bit more complicated given the legal rules of each country. For example in some European countries and some Islamic banks: the property transfer tax is not paid twice when buying a property – once by the bank, once by the customer – they both form a company, buy the house together, and then the bank makes a withdrawal.
Many devout Muslims who did not want an interest-linked loan and would therefore have been renting out their homes are now using this financing model to purchase their own home. Money is invested in the real economy, so things and goods are bought with it, and the customer participates in the success of his investment in the model of profit and loss sharing.
Islamic banking services
With Islamic banking, there is a theory on the one hand and actual practice on the other. Concretely, the models are designed in such a way that they replicate traditional deposit transactions. The customer receives an income corresponding to the interest rate of a conventional bank. If there are weak years, Islamic banks usually keep earnings equalization reserves ready.
How does an Islamic bank work?
Interest-free and close to the real economy – a bank that offers Islamic-compliant financial products is based on Islamic banking guidelines. Islamic banking refers to the management of banking and financial transactions that are in line with the religious and moral norms and rules of Islam’s values and obligations towards social responsibility.
The passwords of Islamic banking are – the real economy without interest and the prohibition of speculation. The ban on interest is probably the most well-known distinguishing feature between conventional and Islamic banking. In addition, according to the Islamic beliefs of Muslims, every transaction and every transfer should be clear and understandable to those involved, and free from extreme risks, gambling, speculation, and elements harmful to society.
Investing in debtor companies is not permitted in Islam and therefore in Islamic banking. The Islamic banking system also provides for ethical exclusion criteria: these include, among other things, a ban on investment in the production and distribution of alcohol, in the tobacco industry, in armaments, and in the manufacture and trade of pork.
Islamic banking system
I have always wondered how Islamic banking works and how it differs from other banks and after doing a lot of research I will explain to you how Islamic banking works in this post. First, I would like to define what Islamic banking is.
Islamic banking refers to the banking business or system of banking activities based on the principles of Sharia (Islamic law). Under Islamic law, banks are not allowed to engage in activities that involve (giving and receiving) interest. The prohibition of paying or charging fixed interest is based on the Islamic teaching that money is only a medium of exchange. It has no intrinsic value, so you shouldn’t make more money by making fixed interest payments just because you’re depositing something in a bank or lending something to someone else. So how does an Islamic bank work?
Islamic banks do not lend money directly to the customer as traditional banks do, but rather by the primary product (house, car, refrigerator) and then rent or sell it in installments to customers at a fixed price, which is usually higher than the original market value.
The main idea here is risk-sharing – the banks make a profit from the transaction as a reward for the risk they took with the client. Instead of living on interest, Islamic banks use their clients’ money to purchase assets such as real estate or a business and profit when the loan is successfully repaid.
Comparison between an Islamic bank and a regular bank
Example: Suppose Mr. A wants to buy a car. The car is worth a million. He goes to a conventional bank. The bank lends him money at an interest rate of 4% (several factors determine the interest rate). Then he buys the car. So the relationship between Bank and Mr. A is that of borrower and lender.
Now consider the second scenario: Mr. A wants to buy a car and visit an Islamic bank. The bank asks him to choose the car first (i.e., model, specification, etc.), then the bank buys the car for 1 million and sells it to Mr. A for 1.1 million. This is an additional 100 thousand of the bank’s profit. (Again many factors determine the rate of profit) Now the relationship between Bank and Mr. A is changing from lender and borrower to seller and buyer.
In conventional banks, almost all products are interest-based, while in Islamic banks all financing products are different. Based on the contractual relationship between the bank and the customer.