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Islamic banking is predicated on Islamic law (Shariah) principles derived from Scripture and Traditions. Any venture forbidden in the Sacred Law applies to bank transactions. In essence, Islamic law prohibits usury, i.e. the collection and payment of interest (commonly called Lariba - no interest).
Islamic law also prohibits investing in businesses that are considered unlawful or Haraam (businesses that sell alcohol or pork, engage in gambling, or media businesses that engage in pornography or scandal). There are a number of specialized Islamic banks in many countries that service this banking need. Islamic banks, or Islamic banking divisions of ordinary banks, are required to establish a Shariah Board, comprised mainly of Islamic clergy and scholars, to advise them on Shariah principles.
An example: if LCC 10 000 is borrowed from an Islamic bank, the borrower need only pay LCC 10 000 to the bank, plus a service fee, which will be the costs the bank incurred to acquire and lend the cash. No unrelated amount may be imposed on the borrower. Some banks in Muslim countries use the euphemism "service charges" for the interest charged on their loans to circumvent laws prohibiting usury.
Islamic Law permits the trade in assets, and some Islamic banks focus on this area of business. For example, if an individual wants to buy a motor vehicle from a dealer, s/he will inform a bank that provides such a service. The bank will purchase the vehicle from the dealer and sell it to the purchaser who repays for the loan in set monthly installments until the debt is settled. The installment includes a predetermined mark-up, which includes a service fee.
Those in agreement with lending on the basis of an explicit mark-up being set state that the mark-up reimburses the bank to an extent commensurate with the risk it undertakes. However, there are many Muslims who contend that this type of lending is contrary to the principles of Islamic law.
Like any bank, an Islamic bank can accept deposits. This money is then invested in permitted ventures such as the purchase of property from which rental income can be derived. The depositor benefits (loses) proportionately from a positive (negative) rate of return on the principal invested; thus it is known as shared risk-and-reward banking. Any amount spent by the bank on the protection and administration of deposits can be retrieved from the depositor through the imposition of service fees.
Islamic banks are normal banks in respect of prudential requirements.
Most developing countries have development banks. They are owned by government and are usually brought into being by separate statute. The statute spells out the activities of the bank, the ministry responsible for its oversight, etc. The capital of development banks is voted by Parliament, and when new funds are required the bond market is accessed.
Most development banks are focused on specific areas such as agriculture, local authorities and industry.
Micro-credit banking is the lending by specialist banks of small amounts of funds to small entrepreneurs for the purpose of the purchase of tools (for the production of goods), raw materials (to be beneficiated or used for the production of other goods) or goods for resale. The world's best example of successful micro-credit banking is Grameen Bank of Bangladesh. Grameen Bank37 describes its underlying premise as follows:
"The underlying premise of Grameen is that, in order to emerge from poverty and remove themselves from the clutches of usurers and middlemen, landless peasants need access to credit, without which they cannot be expected to launch their own enterprises, however small these may be. In defiance of the traditional rural banking postulate whereby "no collateral (in this case, land) means no credit", the Grameen Bank experiment set out to prove - successfully - that lending to the poor is not an impossible proposition; on the contrary, it gives landless peasants the opportunity to purchase their own tools, equipment, or other necessary means of production and embark on income-generating ventures which will allow them escape from the vicious cycle of "low income, low savings, low investment, low income". In other words, the banker's confidence rests upon the will and capacity of the borrowers to succeed in their undertakings."
Grameen Bank describes its mode of operation as follows:
"A bank branch is set up with a branch manager and a number of centre managers and covers an area of about 15 to 22 villages. The manager and the workers start by visiting villages to familiarize themselves with the local milieu in which they will be operating and identify the prospective clientele, as well as explain the purpose, the functions, and the mode of operation of the bank to the local population. Groups of five prospective borrowers are formed; in the first stage, only two of them are eligible for, and receive, a loan. The group is observed for a month to see if the members are conforming to the rules of the bank. Only if the first two borrowers begin to repay the principal plus interest over a period of six weeks, do the other members of the group become eligible themselves for a loan. Because of these restrictions, there is substantial group pressure to keep individual records clear. In this sense, the collective responsibility of the group serves as the collateral on the loan."
As regards loan size, purpose of the loans, the rate of interest charged, and the repayment rate, and the source of funds, Grameen Bank reports:
"Loans are small, but sufficient to finance the micro-enterprises undertaken by borrowers: rice-husking, machine repairing, purchase of rickshaws, buying of milk cows, goats, cloth, pottery etc. The interest rate on all loans is 16 percent. The repayment rate on loans is currently - 95 per cent - due to group pressure and self-interest, as well as the motivation of borrowers."
As these banks are usually agencies of government departments, their capital is provided by the relevant department. In cases where the bank is formed under its own statute the capital is voted by Parliament, and when new funds are required the bond market is accessed. In some cases these banks take deposits.