Islamic banking and finance

Overview

Islamic banking, Islamic finance (Arabic: مصرفية إسلامية masrifiyya 'islamia), or Sharia-compliant finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic economics. Some of the modes of Islamic finance include mudarabah (profit-sharing and loss-bearing), wadiah (safekeeping), musharaka (joint venture), murabahah (cost-plus), and ijarah (leasing). Sharia prohibits riba, or usury, generally defined as interest paid on all loans of money (although some Muslims dispute whether there is a consensus that interest is equivalent to riba). Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haram ("sinful and prohibited"). These prohibitions have been applied historically in varying degrees in Muslim countries/communities to prevent un-Islamic practices. In the late 20th century, as part of the revival of Islamic identity, a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community. Their number and size has grown, so that by 2009, there were over 300 banks and 250 mutual funds around the world complying with Islamic principles. By 2024, estimates of total Sharia-compliant assets ranged from US$3.88 trillion according to the Islamic Financial Services Board's Stability Report 2025, to US$5.98 trillion according to the ICD–LSEG Islamic Finance Development Report 2025, which applied a broader definition of the Islamic economy across 140 countries. The Gulf Cooperation Council region accounted for the largest share at 53.1% of IFSB-measured assets, followed by East Asia and the Pacific at 21.9%, driven by Malaysia and Indonesia. Although Islamic banking still makes up only a fraction of the banking assets of Muslims, since its inception it has been growing faster than banking assets as a whole, and is projected to continue to do so. The Islamic banking industry has been lauded by devout Muslims for returning to the path of "divine guidance" in rejecting the "political and economic dominance" of the West, and noted as the "most visible mark" of Islamic revivalism; its advocates foresee "no inflation, no unemployment, no exploitation and no poverty" once it is fully implemented. However, it has also been criticized for failing to develop profit and loss sharing or more ethical modes of investment promised by early promoters, and instead merely selling banking products that "comply with the formal requirements of Islamic law", but use "ruses and subterfuges to conceal interest", and entail "higher costs, bigger risks" than conventional (ribawi) banks.

Usury in Islam

Islamic finance is based upon the belief that "all forms of interest are riba and hence prohibited". The word "riba" literally means "excess or addition", and has been translated as "interest", "usury", "excess", "increase" or "addition". According to Islamic economists Choudhury and Malik, the elimination of interest followed a "gradual process" in early Islam, "culminating" with a "fully fledged Islamic economic system" under Caliph Umar (634–644 CE). Other sources (Encyclopedia of Islam and the Muslim World, Timur Kuran), do not agree, and state that the giving and taking of interest continued in Muslim society "at times through the use of legal ruses (ḥiyal), often more or less openly," including during the Ottoman Empire. Still another source (International Business Publications) states that during the "Islamic Golden Age" the "common view of riba among classical jurists" of Islamic law and economics was that it was unlawful to apply interest to gold and silver currencies, "but that it is not riba and is therefore acceptable to apply interest to fiat money—currencies made up of other materials such as paper or base metals—to an extent." In the late 19th century Islamic modernists reacted to the rise of European power and influence and the European colonization of Muslim countries by reconsidering the prohibition on interest and whether interest rates and insurance were not among the "preconditions for productive investment" in a functioning modern economy. Syed Ahmad Khan, argued for a differentiation between sinful riba "usury", which they saw as restricted to charges on lending for consumption, and legitimate non-riba "interest", for lending for commercial investment. However, in the 20th century, Islamic revivalists, Islamists, and other Islamic activists worked to define all interest as riba, to enjoin Muslims to lend and borrow at "Islamic banks" that avoided fixed rates. By the 21st century this Islamic banking movement had created "institutions of interest-free financial enterprises across the world". Loans are permitted in Islam if the interest that is paid is linked to the profit or loss obtained by the investment. The concept of profit acts as a symbol in Islam of equal sharing of profits, losses, and risks. The movement started with activists and scholars such as Anwar Qureshi, Naeem Siddiqui, Abul A'la Maududi, Muhammad Hamidullah, in the late 1940 and early 1950s. They believed commercial banks were a "necessary evil," and proposed a banking system based on the concept of mudarabah, where shared profit on investment would replace interest. Further works specifically devoted to the subject of interest-free banking were authored by Muhammad Uzair (1955), Abdullah al-Araby (1967), Mohammad Najatuallah Siddiqui, al-Najjar (1971) and Muhammad Baqir al-Sadr.

Since 1970

The involvement of institutions, governments, and various conferences and studies on Islamic banking (the Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977) were instrumental in applying the application of theory to practice for the first interest-free banks. At the First International Conference on Islamic Economics, "several hundred Muslim intellectuals, Sharia scholars and economists unequivocally declared ... that all forms of interest" were riba. By 2004, the strength of this belief (which is the basis of Islamic finance) was demonstrated in Pakistan—when a minority (non-Muslim) member of the Pakistani parliament questioned it, pointing out that a scholar from Al-Azhar University (one of the oldest Islamic universities in the world), had issued a decree that bank interest was not un-Islamic. His statement resulted in "pandemonium" in the parliament, a demand by members of the leading Islamist political party to immediately respond to these allegedly derogatory remarks, followed by a walkout when they were denied it. When the upset members of parliament returned, their leader (Sahibzada Fazal Karim), stated that since the Pakistan Council of Islamic ideology had decreed that interest in all its forms was haram (forbidden) in an Islamic society, no member of parliament had the right to "negate this settled issue". The council's decree notwithstanding, over the years a minority of Islamic scholars (Muhammad Abduh, Rashid Rida, Mahmud Shaltut, Syed Ahmad Khan, Fazl al-Rahman, Muhammad Sayyid Tantawy and Yusuf al-Qaradawi) have questioned whether riba includes all interest payments. Others (Muhammad Akran Khan) have questioned whether riba is a crime like murder and theft, forbidden by Sharia (Islamic law) and subject to punishment by human beings, or simply a sin to be inveighed against, with the reprimand left to God, since "neither the Prophet nor the first four caliphs nor any subsequent Islamic government ever enacted any law against riba." With an increase in the Muslim population in Europe and the current lack of supply, opportunities will arise for the important role which Islamic finance plays in Europe's economy. In particular, Luxembourg is emerging as a leader and hub for Islamic funds.

Banking

While revivalists like Mohammed Naveed insist Islamic banking is "as old as the religion itself with its principles primarily derived from the Quran", secular historians and Islamic modernists see it as a modern phenomenon or "invented tradition".

Early example: Zubayr ibn al-Awwam

It is argued that in practice the fundraising business of Zubayr ibn al-Awwam was banking with zero interest. Zubayr pioneered this practice by technically modifying the money-keeping service to be a loan which Zubayr was obligated to pay off, while he also got privilege to manage the money he kept to do his business. Zubayr's practice of accepting deposits while not charging any interest meant Zubayr died with an inflated debt of 2,000,000 Dinar. However, Zubayr invested his clients' deposits in his own lucrative businesses, so his inheritors managed to settle his debts while still leaving an inheritance for his family. After his death, his son Abdullah ibn Zubayr sold the property for 1.600.000 dinar. This practice was allowed according to classical scholar consensus, such as Ibn Taymiyyah in his Majmu Fatawa.

Early banking

According to Timur Kuran, by "the tenth century, Islamic law supported credit and investment instruments" that were "as advanced" as anything in the non-Islamic world, but prior to the 19th century there were no "durable" financial institutions "recognizable as banks" in the Muslim world. The first Muslim majority-owned banks did not emerge until the 1920s. An early market economy and an early form of mercantilism, sometimes called Islamic capitalism, was developed between the eighth and twelfth centuries. The monetary economy of the period was based on the widely circulated currency the gold dinar, and it tied together regions that were previously economically independent. A number of economic concepts and techniques were applied in early Islamic banking, including bills of exchange, partnership (mufawada, including limited partnerships, or mudaraba), and forms of capital (al-mal), capital accumulation (nama al-mal), cheques, promissory notes, trusts (see Waqf), transactional accounts, loaning, ledgers and assignments. Muslim traders are known to have used the cheque or ṣakk system since the time of Harun al-Rashid (9th century) of the Abbasid Caliphate. Organizational enterprises independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.

20th century

In the middle of the 20th century, some organizational entities were found to offer financial services complying with Islamic laws. The first, experimental, local Islamic bank was established in the late 1950s in a rural area of Pakistan. It charged no interest on its lending. In 1963, the first modern Islamic bank on record was established in rural Egypt by economist Ahmad Elnaggar to appeal to people who lacked confidence in state-run banks. The profit-sharing experiment, in the Nile Delta town of Mit Ghamr, did not specifically advertise its Islamic nature for fear of being seen as a manifestation of Islamic fundamentalism, which was anathema to the Gamal Nasser regime. Also in that year the Pilgrims Saving Corporation was founded in Malaysia. Although not a bank, it incorporated basic Islamic banking concepts. The Mit Ghamr experiment was shut down by the Egyptian government in 1968. Nonetheless, it was considered a success by many, as by that time there were nine similar banks in the country. In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank, which as of 2016 was still in business in Egypt.

Since 1970

The influx of "petro-dollars" and a "general re-Islamisation" following the 1973 Arab Israeli War and 1973 oil crisis encouraged the development of the Islamic banking sector, and since 1975 it has spread globally. In 1975, the Islamic Development Bank was set up with the mission of providing funding to projects in its member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, was established in 1979. The first Islamic insurance (or takaful) company – the Islamic Insurance Company of Sudan – was established in 1979. The Amana Income Fund, the world's first Islamic mutual fund (which invests only in Sharia-compliant equities), was created in 1986 in Indiana. From 1980 to 1985, Islamic investments underwent a "spectacular expansion" throughout the Muslim world, attracting deposits with the promise of "great gains" and "religious guarantees" supplied by Islamic jurists who were "recruited to issue fatwas denouncing conventional banks and recommending their Islamic rivals." This growth was temporarily reversed in 1988 in the largest Arab Muslim country, Egypt, when the Egyptian state – worried that Islamist movements were building up a "war chest" and being given financial independence – reversed its tacit support for the industry, and launched a media campaign against Islamic banks. The ensuing financial panic led to the bankruptcy of some companies. In 1990 an accounting organization for Islamic financial institutions (Accounting and Auditing Organization for Islamic Financial Institutions, AAOIFI), was established in Algiers by a group of Islamic financial institutions. Also in that year the Islamic bond market emerged when the first tradable sukuk – the Islamic alternative to conventional bonds – were issued by Shell MDS in Malaysia. In 2002, the Malaysia-based Islamic Financial Services Board (IFSB) was established as an international standard-setting body for Islamic financial institutions. By 1995, 144 Islamic financial institutions had been established worldwide, including 33 government-run banks, 40 private banks, and 71 investment companies. The large US-based Citibank began to offer Islamic banking services in 1996 when it established the Citi Islamic Investment Bank in Bahrain. The first successful benchmark for the performance of Islamic investment funds was established in 1999, with the Dow Jones Islamic Market Index (DJIMI).

Also in the 1990s, a false start was made in Islamic banking in the UK, where bankers declared returns "interest" for tax purposes, while insisting to depositors they were actually "profit" and so not riba. Islamic scholars issued a fatwa stating they had "no objection to the use of the term 'interest'" in loan contracts for purposes of tax avoidance provided the transaction did not actually involve riba, and the Islamic bankers used the term for fear that lack of tax deductions available for interest (but not profit) would put them at a competitive disadvantage to conventional banks. Muslim customers were not persuaded, and a "bad taste" was left "in the mouth" of the market for Islamic financial products. The Islamic Bank of Britain, the first Islamic commercial bank established outside the Muslim world, was not established until 2004. By 2008 Islamic banking was growing at a rate of 10–15% per year and continued growth was forecast. There were over 300 Islamic financial institutions spread over 51 countries, as well as an additional 250 mutual funds complying with Islamic principles. Worldwide, approximately 0.5% of financial assets were estimated to be under Sharia-compliant management according to The Economist magazine. But, as the industry grew, it also drew criticism (from M.T. Usmani among others) for not progressing from "debt-based contracts", such as murabaha, to the more "genuine" profit and loss sharing mode, but instead moving in the opposite direction, "competing to present themselves with all of the same characteristics of the conventional, interest-based marketplace". During the 2008 financial crisis, Islamic banks were not initially impacted by the 'toxic assets' built up on the balance sheets of US banks as these were not Sharia-compliant and not owned by Islamic banks. In 2009, the official newspaper of the Vatican (L'Osservatore Romano) put forward the idea that "the ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service". (The Catholic Church also forbids usury, but began to relax its ban on all interest in the 16th century.) However, the drop in valuation of real estate and private equity – two segments heavily invested in by Islamic firms – following the collapse of Lehman Brothers Islamic did hurt Islamic financial institutions. As of 2015, $2.004 trillion in assets were being managed in a Sharia-compliant manner according to the State of the Global Islamic Economy Report. Of these $342 billion were sukuk. The market for Islamic sukuk bonds in that year was made up of 2,354 sukuk issues, and had become strong enough that several non-Muslim majority states – UK, Hong Kong, and Luxembourg – issued sukuk. There are multiple Sharia-compliant indexes, created by Sharia screening of companies. Such indexes include DJIM, S&PSI, MSCI and country-based indexes like KMI-Pakistan and SCM-Malaysia.

Principles

To be consistent with the principles of Islamic law (Sharia)—or at least an orthodox interpretation of the law—and guided by Islamic economics, the contemporary movement of Islamic banking and finance prohibits a variety of activities, some of which are not illegal in secular states:

Paying or charging interest. "All forms of interest are riba and hence prohibited". Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to prevent use of interest. Investing in businesses involved in activities that are forbidden (haram). These include things such as selling alcohol or pork, or producing media such as gossip columns or pornography. Charging extra for late payment. This applies to murâbaḥah or other fixed payment financing transactions, although some authors believe late fees may be charged if they are donated to charity, or if the buyer has "deliberately refused" to make a payment. Maisir. This is usually translated as "gambling" but used to mean "speculation" in Islamic finance. Involvement in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future is maisir and forbidden in Islamic finance. Gharar. Usually translated as "uncertainty" or "ambiguity". Bans on both maisir and gharar tend to rule out derivatives, options and futures. Islamic finance supporters (such as Mervyn K. Lewis and Latifa M. Algaoud) believe these involve excessive risk and may foster uncertainty and fraudulent behaviour such as are found in derivative instruments used by conventional banking. Engaging in transactions lacking "'material finality'. All transactions must be "directly linked to a real underlying economic transaction", which excludes "options and most other derivatives". Money on the most common type of Islamic financing – debt-based contracts – "must be made from a tangible asset that one owns and thus has the right to sell – and in financial transactions it demands that risk be shared." Money cannot be made from money. Another statement of the Islamic banking theory of finance is: "Money has no intrinsic utility; it is only a medium of exchange." Other restrictions include:

Islamic banks are to collect zakat (obligatory religious alms giving) from customers' accounts – at least according to some sources. A board of Sharia experts is to supervise and advise each Islamic bank on the propriety of transactions to "ensure that all activities are in line with Islamic principles". (Interpretations of Sharia may vary by country. According to Humayon Dar, interpretation of the Sharia is more strict in Turkey or Arab countries than in Malaysia, whose interpretation is in turn more strict than the Islamic Republic of Iran. Mohammed Ariff also found less exacting Sharia compliance in Iran, where the Islamic government had decreed "that government borrowing on the basis of a fixed rate of return from the nationalized banking system would not amount to interest" and consequently would be permissible." Mahmud el-Gamal found interpretations to be most strict in Sudan and least in Malaysia.) Risk sharing. Symmetrical risk and return on distribution to participants must be structured such that no one benefits disproportionately from the transaction. In general, Islamic banking and finance has been described as having the "same purpose" as conventional banking but operating in accordance with the rules of Sharia law (Institute of Islamic Banking and Insurance), or having the same "basic objective" as other private entities, i.e. "maximization of shareholder wealth" (Mohamed Warsame). In a similar vein, Mahmoud El-Gamal states that Islamic finance "is not constructively built from classical jurisprudence". It follows conventional banking and deviates from it "only insofar as some conventional practices are deemed forbidden under Sharia." A broader description of its principles is given by the Islamic Research and Training Institute of the Islamic Development bank:

The most important feature of Islamic banking is that it promotes risk sharing between the provider of funds (investor) on the one hand and both the financial intermediary (the bank) and the user of funds (the entrepreneur) on the other hand ... In conventional banking, all this risk is borne in principle by the entrepreneur. Some proponents (Nizam Yaquby) believe Islamic banking has more far reaching purposes than conventional banking, and declare that the "guiding principles" for Islamic finance include: "fairness, justice, equality, transparency, and the pursuit of social harmony", although others describe these virtues as the natural benefits of following Sharia. (Taqi Usmani describes the virtues as guiding principles in one section of his book on Islamic Banking, and benefits in another.) Nizam Yaquby, for example, declares that the "guiding principles" for Islamic finance include: "fairness, justice, equality, transparency, and the pursuit of social harmony". Some distinguish between Sharia-compliant finance and a more holistic, pure and exacting Sharia-based finance. "Ethical finance" has been called necessary, or at least desirable, for Islamic finance, as has a "gold-based currency". Taqi Usmani declares that Islamic banking would mean less lending because it paid no interest on loans. This should not be thought of as presenting a problem for borrowers finding funds, because – according to Usmani – it is in part to discourage excessive finance that Islam forbids interest. Zubair Hasan argues that the objectives of Islamic finance as envisaged by its pioneers were "promotion of growth with equity ... the alleviation of poverty ... [and] a long run vision to improve the condition of the Muslim communities across the world." Some (such as Umar Ibrahim Vadillo) believe the Islamic banking movement has so far failed to follow the principles of Sharia law, or at least failed to follow them sufficiently strictly. On the other hand, Usmani preached that an Islamic economy free of the "imbalances" in society – such as concentration of "wealth in the hands of the few", or monopolies which paralyze or hinder market forces – would follow from obeying "divine injunctions" by banning interest (along with other Islamic efforts). (Later in his book Introduction to Islamic Finance, he argues that Islamic principles should include "the fulfillment of the needs of the society" giving "preference to the products which may help the common people to raise their standard of living", but that few Islamic banks have followed this path.) Another source (Saleh Abdullah Kamel), described the changes anticipated for the Muslim community by following Islamic approach to economics, banking, finance, etc., as a "move towards economic development, creation of the value added factor, increased exports, less imports, job creation, rehabilitation of the incapacitated and training of capable elements".

Scriptural basis

The Sharia law that forms the basis of Islamic banking is itself based on the Quran (revealed to the Islamic prophet Muhammad) and hadith (the body of reports of the teachings, deeds and sayings of the Islamic prophet Muhammad that often explain verses in the Quran). Prohibition of gharar is based on hadith declaring as forbidden gharar, the sale of things like "the birds in the sky or the fish in the water". Maisir is thought to be banned by verses 2:219, 5:90, and 91 in the Quran. However, "the Islamic evaluation" of modern banking centers around the definition of interest on loans as riba. Twelve verses in the Qur'an deal with riba, the word appearing eight times in total, three times in verses 2:275, and once in 2:276, 2:278, 3:130, 4:161 and 30:39. Riba is mentioned numerous times in hadith, including Muhammad's Farewell Sermon. A number of orthodox scholars point to Quranic verses (2:275–2:280) as declaring riba "categorically prohibited" and "unjust" (zulm), and defining it to mean any payment "over and above the principal" of a loan. (Although at least one source states "it is commonly argued" that riba is "defined by hadith".)

Those who consume interest will stand ˹on Judgment Day˺ like those driven to madness by Satan’s touch. That is because they say, “Trade is no different than interest.” But Allah has permitted trading and forbidden interest. Whoever refrains—after having received warning from their Lord—may keep their previous gains, and their case is left to Allah. As for those who persist, it is they who will be the residents of the Fire. They will be there forever. Allah has made interest fruitless and charity fruitful. And Allah does not like any ungrateful evildoer. Indeed, those who believe, do good, establish prayer, and pay alms-tax will receive their reward from their Lord, and there will be no fear for them, nor will they grieve. O believers! Fear Allah, and give up outstanding interest if you are ˹true˺ believers. If you do not, then beware of a war with Allah and His Messenger! But if you repent, you may retain your principal—neither inflicting nor suffering harm.If it is difficult for someone to repay a debt, postpone it until a time of ease. And if you waive it as an act of charity, it will be better for you, if only you knew. According to the orthodox, an "increase over the principal sum" in loans of cash is riba. An increase over the principal sum in financing a purchase of some product or commodity is another matter. These are not riba according to the orthodox interpretation – at least in some circumstances. (These are sometimes known as "credit sales".) According to noted Islamic scholar Taqi Usmani, this is because in Quran aya 2:275 ("they say, 'Trafficking (trade) is like usury,' [but] God has permitted trafficking, and forbidden usury") "trafficking (trade)" refers to credit sales such as murabaha, the "forbidden usury" refers to charging extra for late payment (late fees), and the "they" refers to non-Muslims who did not understand why if the first was allowed both were not. For this reason (according to Usmani) it is not true that "whenever price is increased taking the time of payment into consideration, the transaction comes within the ambit of interest". Instead of "principal" and "interest rate", the credit taker is paying "cost" and "profit rate". (Another difference with conventional finance is that there is no penalty for late payment.)

Interest and credit sales

While Usmani and other Islamic banking pioneers envisioned credit sales like murâbaḥah being a limited part of the Islamic banking industry and subordinate to profit and loss sharing, it has become the "most common" mode of Islamic financing. The distinction between credit sales and interest has also come under attack from critics such as Khalid Zaheer and Muhammad Akram Khan, criticizing it from opposite points of view. Zaheer considers profit from credit sales to be riba, the same as interest, and notes the lack of enthusiasm of orthodox scholars (such as the Council of Islamic Ideology) for credit sales-based Islamic banking, which the council calls "no more than a second best solution from the viewpoint of an ideal Islamic system". Khan calls the distinction "frivolous and laboured", a way of charging interest using another name, necessary because businesses "cannot survive where cash and credit prices are equal". Others note that in terms of standard accounting practice and truth-in-lending regulations, getting 90 days credit on a Rs 10000 product and paying an extra Rs 500, cost very nearly the same and is considered very nearly the same as paying in cash, using a three-month loan at 20% per annum. Taqi Usmani, however, explains that this is a "misconception". Paying more for credit when buying a product ("an exchange of commodities for money") does not violate Sharia law, but exchange of "one unit of money for another of the same denomination" ("an exchange of money for money") and charging for credit is a violation of Sharia. The cash loan is different because "money has no intrinsic utility". Other orthodox supporters (such as Kahf) have defended the Sharia-compliance of the practice saying that among other things, attaching commodities to money in finance prevents money from being used for speculative purposes. Critics report widespread abuses of "synthetic" murabaha, which are loans with interest in all but name.

Types of Islamic lending

One of the pioneers of Islamic banking, Mohammad Najatuallah Siddiqui, suggested a two-tier mudarabah model as the basis of a riba-free banking. The bank would act as the capital partner in mudarabah accounts with the depositor on one side and the entrepreneur on the other side. (Another pioneer Taqi Uthmani called mudarabah and another profit-sharing form of finance musharakah, the "real and ideal instruments of financing in Shari‘ah".) This model would be supplemented by a number of fixed-return models—mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam) and cash advances for the manufacture of assets (istisna'), etc. In practice, the fixed-return models, in particular the murabaha model, became the industry staples, not supplements, as they bear results most similar to interest-based finance models. Assets managed under these products far exceed those in "profit-loss-sharing modes" such as mudarabah and musharakah.