Islamic Banking and Finance: A Shariah-Based Perspective on Riba and Modern Commercial Banking

Islamic banking and finance is a financial system that operates in accordance with the principles of Shariah (Islamic law). Unlike the conventional banking model, which is based largely on interest (riba) and speculative activities, Islamic finance adheres to strict ethical, moral, and legal codes derived from the Qur’an and the authentic Sunnah of the Prophet Muhammad ﷺ. Its goal is to ensure justice, transparency, and fairness in all financial transactions.

What is Islamic Banking and Finance?

Islamic banking is a system of banking that follows Islamic legal and ethical principles. It prohibits interest (riba), uncertainty (gharar), and gambling (maysir) in transactions. Instead, it promotes risk-sharing, asset-backed financing, and transactions that contribute to real economic activity.

Core principles of Islamic finance include:

• Prohibition of Riba (interest): No form of interest is allowed in any transaction.
• Risk-sharing: Both lender and borrower share the risks and rewards.
• Asset-backed financing: All financial transactions must be linked to tangible assets.
• Ethical investments: Investments must be made in halal (permissible) industries.

Some of the key instruments used in Islamic finance include:

1. Murabaha – Cost-plus-profit sale
2. Mudarabah – Profit-sharing partnership
3. Musharakah – Joint venture partnership
4. Ijarah – Leasing
5. Sukuk – Islamic bonds based on asset ownership

Explanation of Key Instruments in Islamic Finance

1. Murabaha (مرابحة) Murabaha is a cost-plus financing arrangement. In this model, the bank purchases a good requested by the client and then sells it to the client at a declared profit margin. The key aspect is that both the cost and the profit are known to all parties involved, and the transaction is backed by a tangible asset.

• Example: A customer wants to buy a car. The bank buys the car and sells it to the customer at a higher price, which the customer pays in installments.
• No interest is charged; rather, the profit margin is fixed and agreed upon.

2. Mudarabah (مضاربة) Mudarabah is a profit-sharing partnership where one party provides capital (rabb-ul-maal), and the other provides expertise and management (mudarib). Profits are shared according to a pre-agreed ratio, but losses are borne solely by the capital provider unless caused by misconduct or negligence of the manager.

• Used in investment accounts and business financing
• Encourages entrepreneurship and shared risk

3. Musharakah (مشاركة) Musharakah is a joint venture in which all partners contribute capital and share profits and losses according to their respective ratios. It is often used in home financing or project development.

• All partners have a say in decision-making
• Losses are shared in proportion to the capital invested

4. Ijarah (إجارة) Ijarah refers to an Islamic leasing agreement. The bank purchases an asset and leases it to the client for a fixed rental fee. Ownership remains with the bank during the lease term, but it may be transferred to the client at the end (Ijarah wa Iqtina).

• Common in vehicle, equipment, or property leasing
• Rent is charged, not interest

5. Sukuk (صكوك) Sukuk are Islamic bonds that represent ownership in tangible assets, usufructs, or services. Unlike conventional bonds that generate interest, sukuk holders earn returns from the asset’s performance or profit.

• Structured to comply with Shariah law
• Used by governments and corporations for infrastructure or commercial projects

The Conventional Banking System

Modern commercial banks operate largely on the basis of interest. They lend money with an agreed-upon interest rate and earn profits by charging borrowers more than what they pay to depositors. This system is not only centered around riba but also often involves speculative and non-asset-backed financial products.

Key Elements of Conventional Banking:

1. Interest-Based Lending (Riba): Banks lend money at fixed or variable interest rates. Borrowers must repay more than they borrow, regardless of profit or loss, which creates a guaranteed return for the bank and financial pressure for the borrower.
2. Fractional Reserve Banking: Banks keep only a fraction of their deposits as reserves and lend out the rest. This system can create money through credit but often leads to financial instability and inflation.
3. Speculative Instruments: Conventional finance allows investment in speculative and high-risk derivatives, which may lead to artificial asset bubbles and economic crises.
4. Debt Financing: Most transactions are debt-based rather than equity-based, encouraging excessive borrowing and unsustainable personal or corporate debt.
5. No Ethical Screening: Funds can be invested in industries like alcohol, gambling, or weapons manufacturing, which are not permissible under Islamic guidelines.
6. Profit Maximization at Any Cost: Unlike Islamic finance, which prioritizes ethical and social responsibility, conventional banking often focuses on maximizing returns without considering societal impact.

Why Riba is Prohibited in Islam

Riba (interest or usury) is strictly forbidden in Islam. It is considered exploitative and unjust, as it allows the lender to earn a profit without bearing any risk or contributing to economic activity.

Qur’an References:

“Those who devour riba will not stand except as stand one whom the Devil has driven to madness by (his) touch… But Allah has permitted trade and forbidden riba…”
(Surah Al-Baqarah, 2:275)

“O you who believe! Fear Allah and give up what remains due to you of riba, if you are (truly) believers.”
(Surah Al-Baqarah, 2:278)

“If you do not do so, then be informed of a war from Allah and His Messenger…”
(Surah Al-Baqarah, 2:279)

Hadith References:

The Prophet Muhammad ﷺ said:

• “Gold for gold, silver for silver… equal for equal, hand to hand. If these differ, then sell as you wish, provided it is hand to hand.” (Sahih Muslim, 1587)
• “The Messenger of Allah cursed the one who consumes riba, the one who pays it, the one who writes it down, and the two who witness it.” (Sahih Muslim, 1598)

Harmful Effects of Riba:

• Creates social inequality and economic injustice
• Encourages debt-based lifestyles
• Leads to exploitation of the poor
• Promotes speculation and financial instability

How Islamic Finance Addresses These Problems

Islamic finance offers a holistic, ethical, and equitable solution to the deficiencies of conventional banking:

• Encourages partnerships and shared risks
• Ensures financial transactions are backed by real assets
• Discourages excessive speculation and gambling
• Supports ethical investments only
• Aligns financial gain with moral and social responsibility

Modern Challenges and Implementation

Although Islamic banking has grown worldwide, it faces several challenges:

• Lack of global standardization in Shariah interpretations
• Limited public awareness of Islamic finance principles
• Regulatory constraints in non-Muslim majority countries
• Difficulty in completely detaching from global interest-based systems

Despite these challenges, many Islamic banks, scholars, and financial institutions continue to work toward more Shariah-compliant alternatives that meet modern needs while preserving core Islamic values.

Conclusion

Islamic banking and finance offer a practical, ethical, and spiritually fulfilling alternative to conventional systems. Rooted in the Qur’an and the authentic teachings of Prophet Muhammad ﷺ, this system prioritizes justice, equity, and the welfare of all. As Muslims, it is our responsibility to strive for financial systems that reflect our faith, promote fairness, and uphold the commands of Allah ﷻ.

“And Allah has permitted trade and forbidden riba.” (Surah Al-Baqarah, 2:275)

May Allah guide us all toward halal sustenance and protect us from the harm of riba, ameen.