What is Islamic Banking?

Ask a conventional banker exactly what is Islamic banking. He will probably mumble something about religion. He will then say well they cannot charge interest but they use something else which is the same thing. This 'something else', incidentally, is never defined. He will then move on to describe Islamic banking as being about smoke and mirrors. To conclude he will then profoundly announce that, with a few tweaks, it is what he does every day anyway. And that, to him, is the end of it. But, more realistically, what exactly is Islamic banking all about?

Islamic financial institutions are those that are based, in their objectives and operations, on Qur'anic principles. They are thus set apart from 'conventional' institutions, which have no such religious preoccupations. Islamic banks provide commercial services which comply with the religious injunctions of Islam. Islamic banks provide services to their customers free from interest, (the Arabic term for which is riba), and the giving and taking of interest is prohibited in all transactions. This prohibition makes an Islamic banking system differ fundamentally from a conventional banking system.

This rejection of interest poses the central question of what replaces the interest rate mechanism in an Islamic framework. Financial intermediation is at the heart of modern financial systems. If the paying and receiving of interest is prohibited, how do Islamic banks operate? Here Profit and Loss Sharing (PLS) comes into play, substituting profit-and-loss-sharing for interest as a method of resource allocation and financial intermediation.