Islamic banking has become an increasing trend nowadays. Not only Muslims use Islamic banks, however people from other religions also use them as they are believed to be an ethical way of banking. Others use them as they place money in the most profitable investments in order to avoid losing money. The difference between Islamic banking and commercial banking is that Islamic banking follows the shari'a, which prohibits charging interest rates on money which is called riba. According to the shari'a, money isn't a commodity, but it's a method of exchange that should keep circulating continuously for economic activities to take place thus creating more jobs. Islamic banks use Profit Loss Sharing (PLS) which is a contractual agreement between two or more entities, where they merge their resources and use them in a project then share profit and loss. (Dar)
In Islamic banks, investment is done in three ways, whether Musharaka, Mudarabha or Financing on the basis of an estimated rate of return. First of all, Musharaka is when a bank forms a joint venture with another entity, where they share profit and loss according to a previously agreed upon distribution system. While Mudarabha is when a bank is responsible for money and the other party gives expertise management and labor. In Mudarabha profits are shared according to a distribution way that was set in advance, but the bank is responsible for the losses. Financing on the basis of an estimated rate of return, is where the bank assesses the expected profit of the project and provides the money where. In this case, if the project gets excess profit than the estimated one, the client takes the extra money and if the profit is less than expected, then the bank accepts the lower rate. (Abdul Gafoor, Islamic Finance & Information Service) As for trade financing, it is also done in different ways. First of all, mark-up, where the bank buys a product for a client and gets the price and an agreed profit later on in return. Second, leasing where the bank buys the product for the client and rents it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. Hire-purchase is when the bank buys a product for the client and rents it to him for an agreed period of time and amount of money, at the end of that period the client becomes the owner of that item. Sell-and-buy-back is when a client sells one of his assets to the bank for an agreed amount of money paid immediately (now), on the condition that he will buy this asset back after certain time for an agreed price. Letters of credit is when the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis. As for lending, it is also carried out in three different methods, whether loans with a service charge, no-cost loans or overdrafts. Loans with a service charge, is where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge.(Abdul Gafoor, Islamic Finance & Information Service)
In Shari'a, stocks are allowed as the person who buys stocks doesn't know the dividend in advance. On the other hand, preferred stocks are forbidden as their owner guarantees a fixed dividend from time to time, which is similar to interest (Schaik) According to Hakim, although common stocks are legal in Islam, however many actions in stock trading are not. "These practices include speculation, short selling, margin trading, and equity futures and options, all of which would be either severely restricted or unlikely to be acceptable within an Islamic market." Therefore, it is hard for Muslim countries to find an acceptable trading system. (Hakim) Bonds are not allowed according to shari'a as their face value is promised by maturity and as they are bought at less than their face value there's a profit on them, this profit is interest. (Gafoor ) Commodity trading and foreign exchange are also allowed because in foreign exchange you don't know whether the value of money will increase or decrease.
I believe Islamic banking is an ethical way of banking that can protect emerging economies and Islamic nations from financial crisis. Althought it has some drawbacks, it is still an ethical way that if carried out correctly would lead to a better financial condition. According to Abdul Gafoor, "There are four main areas where the Islamic banks find it difficult to finance under the PLS scheme: a) participating in long-term low-yield projects, b) financing the small businessman, c) granting non-participating loans to running businesses" (Abdul Gafoor) First of all, according to Abdul Gafoor, "less than 10% of the total assets goes into medium- and long-term investment ." (Abdul Gafoor) This is because PLS needs time consuming procedures that need experience. Moreover, long-term projects tie up capital for long periods of time. Furthermore, when maturity is longer, it takes more time to realize the profits so it is hard to pay returns to their depositors quickly. (Abdul Gafoor) Another problem is that it is hard to provide small businesses with necessary financing under PLS. The third problem is that it is hard to run businesses under PLS because this needs short-term capital and available cash for on the spot purchasing. (Abdul Gafoor) In spite of the previous disadvantages of Islamic banking, Islamic banks investments are less risky than those of commercial banks so they are more likely to yield higher returns or at least face no losses. Moreover, I believe that if more people start to deposit their money in Islamic banks, Islamic banks will increase in number and in quality and will be more accurate.