Frequently Asked Questions (FAQs) about Islamic Banking

What is Islamic Banking?

Islamic Banking is the type of banking that follows the principles of Shari’ah. This implies that Islamic Banking must uphold the elements permitted and eliminate those prohibited by Shari’ah. The dos and don’ts for Islamic Banking are;

  • Prohibitions: Islamic Financial transactions must not entail elements prohibited by Shari’ah namely payment of interest, products with uncertainty, gambling, as well as the financing of activities that are considered harmful to society (say pornography).
  • Fairness: Islamic Banking requires parties to honor principles of fair treatment and the sanctity of contracts.
  • Real Economic Activities: Transactions must be backed by real assets / economic activities.
  • Risk sharing: There must be sharing of risk and hence profits and losses in economic transactions.

Is Islamic Banking meant for Muslims only?

No. Islamic Banking’s value proposition lies in its key tenets geared towards promoting fairness, transparency and direct linkage with economic activity, which appeal to all individuals regardless of their religious affiliation.

How Do Islamic Financial Institutions offer loans to customers?

Islamic Financial Institutions offer loans to customers under various contracts;
1) DEBT-LIKE FINANCING STRUCTURES; where a Financial Institution buys an asset on behalf of the customer and sells it to the customer at a markup. Or, a Financial Institution leases an asset to the customer, which works like the leases in Conventional Banking. These include:
a) Murabahah (Sales Contract at a Profit Mark-up): Under this contract, the customer (Borrower)
applies to an Islamic Financial Institution for financing to purchase an asset, say a car. The Financial Institution must purchase the car and own it first before reselling it to the customer at price higher than the cost price resulting in a profit to the Financial Institution.
b) Leasing contracts (Ijarah): Islamic Financial Institutions offer leases to customers, which are similar to the leases in Conventional Banking.

2) PROFIT AND LOSS SHARING (PARTNERSHIP) CONTRACTS; where the Financial Institution and the Customer join in a partnership to co-finance a project and share the profits generated from the project based on a pre-agreed profit-sharing ratio. These include:
a) Mudarabah (One Silent Partner and one Active Partner): This is a partnership arrangement in which a Financial Institution provides funds to a customer / borrower for investment in a business venture. The two parties share the profits accruing from the investment in accordance with a pre-agreed ratio, but any losses are borne by the Financial Institution, except where it is confirmed that the losses arose due to the borrower’s negligence, in which case the borrower bears all the losses. In this contract, the Financial Institution is mandated to engage in the day- to-day management of the business / project.
b) Musharakah (Two Active Partners): In this contract, the Financial Institution and the Customer (Borrower) both contribute funds towards a business venture, both parties are expected to participate in the day-to-day management of the business venture and share the profits arising from the investment in accordance with an agreed profit-sharing ratio, while the loss is distributed in proportion to the share of each in the total capital.

Note: Under the partnership contracts, the Borrower gradually buys out the Financial Institution’s stake in the business venture in accordance with an agreed schedule. Based on the above contracts, Islamic Financial Institutions can structure very many contracts.


Since in Islamic Banking, charging of interest is prohibited, how do Financial Institutions offering Islamic Banking products make money?

Financial Institutions offering Islamic Banking products make money through earning profits on trading activities that they engage in, rental income from properties leased to customers and by sharing profits accruing from the projects in which they invest in partnership with the customers.

Since in Islamic Banking, the Financial Institution and the customer share losses, doesn’t it disadvantage the parties involved in a transaction in the event of under performance of a financed project?

No, in practice, Islamic Financial Institutions create reserves called Profit Equalization and Investment Risk Reserves, which are used as a cushion against losses.

How do the Profit Equalization and Investment Risk Reserves work?

The Profit Equalization Reserve is created as an appropriation from profits earned on an investment before the allocation of profits attributable to the Investment Account Depositor and the Financial Institution. In addition to cushioning Investment Account Holders (depositors) against losses, the Profit Equalization Reserve can be used for enhancing dividend payouts to shareholders if deemed necessary by the management of the Financial Institution.
On the other hand, the Investment Risk Reserve is appropriated out of the profits attributable to Investment Account Depositors after deducting the Financial Institution’s profit share. It is solely used to cushion losses, which erode the profits payable to Investment Account Depositors. The customer agrees in advance, in the contract that regulates their relationship with the Financial Institution, on the proportion of their income that may be appropriated to each of these reserves.

Do Islamic Financial Institutions accept customer Deposits like their Conventional counterparts?

Yes, Islamic Financial Institutions licensed by the Central Bank shall accept deposits from customers. The Deposits take on various forms; Savings and Current accounts, which are similar to those in Conventional Banking, and Investment Deposits that are akin to Time Deposits but with different modalities.

Do Islamic Financial Institutions require borrowers to provide collateral for funds granted?

Yes, in a Murabahah (Sales Contract at a Profit Mark-up), the asset being financed acts as security until the customer (borrower) repays the Financial Institutions funds in full. Similarly, under Profit and Loss Sharing (Partnership) contracts, the customer is required to pledge collateral such as tangible assets, guarantees and insurance.

How do Islamic Financial Institutions determine the mark-up charged to customers?

Islamic Financial Institutions calculate their profit mark-up by using available benchmarks such as the ruling market rates as do Conventional Financial Institutions.

Isn’t mark-up the same as interest but simply re-named?

No. The prohibition of interest lies not in the amount of the mark-up or its similarity or equity with interest, but rather in the method of its generation. The key point is that the mark-up is not self- generating (i.e., it does not arise out of money on money like interest, but it is generated as a result of an absolute sale of a real asset).

Source:  Bank of Uganda.