This will be a short one and on a topic that’s not in line with what I usually write about.

Introduction

With many international financial centers having a large Muslim population, the concept of Islamic banking has come up for many who have researched bank account opening in for example Dubai, Ras al-Khaimah, Bahrain, Qatar, Brunei, and so on. Islamic banking also has a history and seeing current growth in countries with a Muslim minority.

Note that Islamic banking is not the same as offshore banking. It is not more secretive than non-Islamic banking. It is also not exclusive to Muslims as it’s simply a Shari’ah compliant financial system, specifically a set of rules called Fiqh al-Muamalat. Anyone can participate.

Opening an Islamic bank account, whether it’s for yourself or your company, and whether you are Muslim or not, is the same as opening any other bank account. Some banks might give you a strange look if you do not fit the usual description of an Islamic banking client, but you would usually have a good reason for picking this type of banking and can simply communicate that to the bank.

Sources as well as definitions vary but somewhere around 0.5% to 2% of the world’s assets are held in Islamic finance.

I am not going to go into every single detail about Islamic banking. Terminology and implementation vary.

In essence, it is very similar to regular banking but some services cannot be offered because they are considered haraam (forbidden).

History

Banking in general has a history going back thousands of years. Records of banking-like activities as old as 2000 BC have been found. The modern banking system is however typically accredited to financial service providers and intermediaries in Venice, Florence, and Genoa in the 13th and 14th century BC.

Islamic banking is both old and new. The concept is as old as Islam (possibly older) but local Islamic banks had been rendered almost completely powerless by western influences in the Middle East and western commercial banks took over.

In the 1950s and 1960s, there was a resurgence of Islamic banking across not only the Middle East but also in the large Muslim communities in South-East Asia. This started in Egypt with the 1963 foundation of Mit Ghamr, the world’s first Islamic bank in modern times.

Mit Ghamr allowed three types of accounts: a savings account that had no interest, an investment account where interest could be earned as return on profit-sharing investment in ethical businesses, and a zakat (زكاة‎) account, which is a mandatory religious tax for charitable purposes.

For geopolitical reasons, the bank did not last very long but paved the way for a modern era of of Islamic banking.

Interest (riba)

This is the most commonly discussed aspect of Islamic banking and since interest lies at the core of banking in general, it is a very important aspect.

Under Islamic banking, a bank cannot earn interest (riba) on money it has lent. Doing so would be haraam. While some interpret this as meaning that any interest in haraam, that is not at all the case. Interest earned in other ways can be permitted.

The reason riba is forbidden is that it is considered unethical to earn money from someone else’s debts.

Mudarabah

The Institute of Islamic Banking and Insurance gives an example of two people, one who has capital and one who has skills but no capital or need capital for a house.

Under the western banking system which is largely based on loans, the capital-owner would lend money to the person with skills and will be paid back the loan amount plus interest. This is irrespective of whether the entrepreneur’s business succeeds.

Under Islamic banking, the two would form a trust-based partnership (Mudarabah) where they agree on ownership ratios and profit sharing. The capital-owner would not be involved in day-to-day operations but can stipulate certain criteria that the entrepreneur would have to honour (within certain limits).

The latter is similar how some Partnership and General Partnership legislations work, with for example one partner investing money (sometimes with full limitation of liability) and one partner uses the money to build a product.

Mudarabah can also apply to investment accounts. While it may appear as if regular interest income is earned, the income is in fact shared between the account holder and the bank.

Conclusion

To recap, Islamic banking is in essence banking under a set of ethical principles.

Contrary to some popular belief, it is neither more secretive than regular banking nor is it limited to Muslims. It is not a zero-interest earning type of banking that can be used to avoid certain exchange of information agreements.

While Islamic banking is based on ethical principles, it is not the same as some ethical investments services offered by banks (western and elsewhere). Ethical investments are simply investments that do not conflict with the investor’s ethical principles, often ruling out trades in weapons, dangerous chemicals, or environmentally harmful goods and services.

For more details on Islamic Banking, head over to the Institute of Islamic Banking and Insurance.