Islamic Banking: Principles and Main Contracts

Islamic banking provides banking services in line with the principles of Shariah (Islamic law). It offers deposits, financing, trade finance and payments like a conventional bank, but it does not charge or pay interest. Instead, returns come from trade, leasing and profit-and-loss sharing arrangements linked to real assets and economic activity. Islamic banking is a significant part of the banking sector in a number of countries, including Bangladesh, where several full-fledged Islamic banks operate alongside Islamic windows of conventional banks.

This guide explains the principles and the main contracts in general educational terms. Whether a particular product complies with Shariah is determined by the bank’s Shariah supervisory board and the standards it follows, such as those issued by AAOIFI.

The core principles

1. Prohibition of riba. Riba, usually translated as interest or usury, is any predetermined excess on a loan of money. Money is treated as a medium of exchange, not a commodity that earns a return simply through the passage of time.
2. Prohibition of excessive uncertainty (gharar). Contracts must be clear about the subject matter, price and terms.
3. Prohibition of gambling and speculation (maysir).
4. Ethical investment. Financing activities considered harmful or prohibited, such as alcohol or gambling, is not permitted.
5. Asset backing and risk sharing. Returns should be linked to real economic activity, and the financier should bear some risk associated with the asset or venture.

The main financing contracts

Murabaha (cost-plus sale)

The bank buys an asset the customer needs and sells it to the customer at cost plus a disclosed profit margin, usually payable in instalments. The bank must own the asset (and bear its risk) before selling it. Murabaha is widely used for trade finance, working capital and consumer goods.

Ijarah (leasing)

The bank buys an asset and leases it to the customer for agreed rentals. The bank retains ownership and the risks of ownership, such as major maintenance and insurance, unless otherwise agreed. In ijarah muntahia bittamleek (lease ending in ownership), ownership passes to the customer at the end, through a separate sale or gift. Ijarah is common for vehicles, equipment and home finance.

Mudarabah (profit-sharing partnership)

One party provides capital (rab al-maal) and the other provides expertise and management (mudarib). Profits are shared in a pre-agreed ratio; financial losses are borne by the capital provider, while the manager loses the value of their effort — unless the loss results from the manager’s negligence or breach of terms. Mudarabah is the basis of many Islamic deposit accounts.

Musharakah (joint venture)

All partners contribute capital, and profits are shared according to an agreed ratio while losses are shared in proportion to capital contributed. In diminishing musharakah, often used for home finance, the bank and customer jointly own a property; the customer pays rent for the bank’s share and gradually buys it out until owning the property fully.

Other contracts

• Salam — advance payment for goods delivered later, used in agriculture.
• Istisna — financing for goods to be manufactured or constructed, paid in stages.
• Wakalah — an agency arrangement in which the bank acts for the customer for a fee.
• Qard hasan — a benevolent loan repaid without any return.
• Sukuk — certificates representing ownership in assets or ventures, often described as Islamic bonds.

How Islamic deposits work

• Current (al-wadiah) accounts are held for safekeeping and payments; the bank guarantees the principal and pays no fixed return.
• Savings and term investment accounts are usually based on mudarabah: depositors share in the profits of the bank’s financing pool according to a pre-agreed ratio. Returns are not fixed in advance, and in principle depositors share losses on the pool.

In practice, many Islamic banks smooth returns using profit equalisation reserves, so depositors’ returns often move in line with market conditions.

Islamic and conventional banking compared

Aspect	Conventional bank	Islamic bank
Basis of return	Interest on loans and deposits	Profit from sale, lease and partnership contracts
Depositor return	Fixed or variable interest	Profit share (investment accounts); no return on safekeeping accounts
Asset link	Not required	Financing must be linked to real assets or ventures
Restrictions	Commercial and regulatory	Also Shariah screening of activities
Governance	Board and regulators	Also a Shariah supervisory board

In economic terms, the pricing of many Islamic financing products tracks market benchmarks, and the end cost to a customer can be similar to conventional finance. The differences lie in the legal structure, the allocation of risks, the restrictions on activities and governance.

Regulation and standards

Islamic banks are regulated by the same central bank as conventional banks and must meet capital, liquidity and reporting requirements, often supplemented by specific guidelines. International bodies include AAOIFI, which issues Shariah, accounting and governance standards, and the Islamic Financial Services Board (IFSB), which issues prudential standards.

Common misunderstandings

• "Islamic banking is interest-free, so it is free." Islamic banks earn profit through sale, lease and sharing contracts; financing has a cost.
• "It is only for Muslims." Islamic banking services are open to anyone.
• "Profit rates are the same as interest rates." They may be benchmarked similarly, but the underlying contracts and risks differ.