Islamic Banking and Finance Definition: History and Example

What Is Islamic Banking?

Islamic banking is a financial system that adheres to financial principles under Sharia law. Islamic banking prohibits the use of interest, speculation, excessive risk, and investing in businesses that go against religious laws while emphasizing profit and loss sharing, fairness, honesty, and transparency with a focus on real economic activities. Islamic banking, or Islamic finance, doesn’t treat money like a commodity and strives to remove harm from financial transactions. Both Muslims and non-Muslims can participate in Islamic banking and benefit from its principles.

Islamic Banking Around the World

The global Islamic banking and finance market is worth $8.94 billion as of 2025 and is expected to grow by 11.6% to $13.89 billion by 2029. The Middle East and Africa region is the largest market, while the Asia-Pacific region is poised to show the most growth. Increasing demand for Sharia-compliant financial services from a younger and growing Muslim population is driving growth in the industry. 

The countries with the highest growth in this area of finance include:

1. Qatar
2. Indonesia
3. Saudi Arabia
4. Malaysia
5. United Arab Emirates

Iraq had the largest number of Islamic banks, with 15, followed by Bahrain (seven) and Qatar (five). Sudan and Saudi Arabia’s Islamic financial institutions held the most assets at $484.0 billion and $322.2 billion, respectively.

Islamic Banking Principles

Islamic banking aims to make finance more equitable by keeping fairness and transparency at the forefront of all transactions. It works on several key principles, including:

• Prohibiting interest: Islamic banking prohibits banks from collecting or paying interest or riba. It is considered exploitative and deepens the divide between rich and poor.
• Risk sharing: Unlike conventional banks, Islamic banks share the risk with their customers.
• Sharing of profit and losses: Banks also share profits and losses with their clients.
• Ethical investing: People who follow Islamic finance principles invest in halal or accepted sectors. Examples of those that are haram or prohibited include gambling, weaponry, and alcohol.
• Avoiding speculation: Islamic finance excludes speculation or gharar since it can cause volatility and instability.

Lending takes on a different form under Islamic banking principles. Rather than providing interest-based loans, these institutions use equity participation in their lending practices. For instance, rather than finance the purchase of a home, an Islamic bank buys the property and either leases or sells it to the client in exchange for a higher fixed installment payment.

History of Islamic Banking

According to the Quran, financial transactions should reflect good governance that specifically includes transparency and accountability. It suggests that wealth should be “supportive” to all community members and that people should avoid indulging in excesses. The use of money should lift others rather than cause harm to others.

Tracing the origins of Islamic banking proves elusive. However, evidence exists of applying religious principles to business and financial transactions—called fiqh al-muamalat. Financial activities that fall under Islamic banking principles include buying and selling, investing, contracts, and saving.

All transactions should adhere to Sharia and be as transparent and fair to all parties involved. Another key is that any financial transaction should have mutual consent, which means they involve the free will of all participants. For instance, lending has traditionally been done without the use of interest.

Example of Islamic Banking

Here’s an example to show how Islamic banking works. Since interest is prohibited, banks do not lend interest-based loans. So if someone wants to make a major purchase, the bank uses the murabaha method, which is a cost-financing system used in Islamic banking and finance. Here’s how it works:

• You see a car that you like that’s selling for $40,000.
• You go to an Islamic bank to finance the purchase.
• The bank purchases the vehicle for $40,000 and sells it to you for $45,000.
• You repay the bank in installments until you have repaid the purchase price.

Savings accounts under Islamic banking principles don’t pay you interest. However, the bank can invest your deposits in investments compliant with Sharia law, sharing the profits earned with you by the bank.

How Is Islamic Banking Different from Conventional Banking?

Islamic banking aims to ensure a fair, transparent, and harmless financial process for all involved. Conversely, conventional banking allows banks and financial institutions to profit while their clients assume a good deal of risk.

The table below highlights these and other key differences between Islamic and conventional banking.