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Abstract

Islamic banking represents a distinct banking paradigm grounded in risk-sharing, asset-backed financing, and ethical constraints derived from Shariah law. Unlike conventional banking, which relies primarily on interest-based debt and financial intermediation detached from real economic activity, Islamic banks operate through contractual arrangements that directly link finance to tangible assets and productive ventures. This article provides a comprehensive, bank-focused academic analysis of Islamic banking, examining its institutional structure, balance-sheet operations, governance mechanisms, and risk management practices. Special attention is given to how Islamic banks function in practice rather than theory, highlighting both their comparative advantages and their structural limitations within modern financial systems.

1. Introduction

Over the past five decades, Islamic banking has evolved from a niche religious experiment into a globally recognized banking industry operating in more than 80 countries. Islamic banks today manage trillions of dollars in assets and coexist alongside conventional banks within dual banking systems. Despite this growth, Islamic banking remains widely misunderstood, often reduced to a simplistic notion of “interest-free banking.” In reality, Islamic banks represent a fundamentally different model of financial intermediation, with distinct implications for bank behavior, risk allocation, profitability, and financial stability.

This article adopts a banking-centric perspective, focusing specifically on how Islamic banks mobilize deposits, allocate credit, manage liquidity, and maintain solvency. The objective is to move beyond abstract theory and provide a realistic, institution-level understanding of Islamic banking as it operates in modern economies.

2. Conceptual Foundations of Islamic Banking

Islamic banking is governed by Shariah principles that directly shape banking operations. The prohibition of riba (interest) eliminates fixed, predetermined returns on loans. Instead, returns must be generated through trade, investment, or leasing activities that involve real economic risk. Additionally, gharar (excessive uncertainty) and maysir (speculation) are prohibited, restricting Islamic banks from engaging in complex derivatives, speculative trading, and purely financial arbitrage.

From a banking perspective, these principles require Islamic banks to function as partners and traders rather than pure lenders. Financing must be linked to identifiable assets, services, or business activities. This structural requirement fundamentally alters the bank’s balance sheet and income-generation mechanisms.

3. Deposit Mobilization and Liability Structure

Islamic banks mobilize funds through two primary types of accounts: current accounts and investment accounts. Current accounts function similarly to demand deposits in conventional banks but are typically structured as qard (benevolent loans), where the bank guarantees principal but does not pay interest. Investment accounts, by contrast, are based on mudaraba contracts, in which depositors act as capital providers and share in the bank’s profits and losses.

This liability structure introduces a unique form of risk-sharing between banks and depositors. Unlike conventional banks, where depositors receive fixed returns regardless of bank performance, Islamic bank investment account holders are theoretically exposed to business risk. In practice, however, many Islamic banks engage in profit-smoothing practices to remain competitive, revealing a tension between Shariah ideals and market realities.

4. Asset-Side Operations and Financing Instruments

On the asset side, Islamic banks rely on a range of Shariah-compliant contracts. Murabaha financing dominates Islamic bank portfolios, involving cost-plus sale transactions that closely resemble conventional credit in economic substance. While often criticized for mimicking interest-based loans, Murabaha remains popular due to its low risk and predictable returns.

Equity-based instruments such as Musharaka and Mudaraba represent the theoretical core of Islamic banking but account for a relatively small share of total assets due to higher risk, information asymmetry, and regulatory capital constraints. Leasing-based instruments (Ijara) and manufacturing finance (Istisna) are widely used in project and infrastructure financing.

5. Risk Management in Islamic Banks

Islamic banks face both conventional banking risks and unique Shariah-related risks. Credit risk arises from counterparty default, while market risk is linked to asset price fluctuations. However, Islamic banks also face displaced commercial risk, where they feel pressure to match conventional bank returns despite operating under profit-sharing principles.

Liquidity risk is particularly acute due to the limited availability of Shariah-compliant money market instruments. Unlike conventional banks, Islamic banks cannot freely access interest-based interbank markets or central bank facilities without special arrangements.

6. Corporate Governance and Shariah Oversight

Islamic banks operate under dual governance systems: conventional corporate governance and Shariah governance. Shariah boards play a critical role in approving products, monitoring compliance, and safeguarding the bank’s religious legitimacy. However, variations in Shariah interpretation across jurisdictions create inconsistencies that complicate cross-border banking operations.

7. Conclusion

Islamic banking constitutes a distinct banking model with unique operational characteristics. While its emphasis on asset-backed financing and risk-sharing offers potential stability benefits, Islamic banks face structural constraints that limit full implementation of their theoretical foundations. A realistic understanding of Islamic banking requires acknowledging both its ethical aspirations and its institutional compromises.