Islamic Banking how is interest free?

Q: If banking were to be based on interest-free transactions how would it work in practice?

Islamic banks like other banks is an institution whose main business is to mobilize funds from savers and user these funds to finance the economic activities of businessmen. While a conventional bank uses the rate of interest for both obtaining funds from savers and lending these funds to businessmen. An Islamic bank performs these functions using various financial modes which are compatible with the Shariah. For mobilizing resources, it uses either the contract of Mudarabah or Wakalah with the funds owners. Under in first contract, the net income of the bank is shared between fund owners and fund providers according to a predetermined profit sharing formula. In the case of loss, the same is shared by fund providers in proportion to the capital contribution. As far as the nature of investment deposits are concerned, these could be either general investment deposit or specific investments’ accounts in which deposits are made for investment in particular projects. In addition, there are current accounts are in nature of an interest free loan to bank. The bank guarantees, the principle in case of current accounts but pays no profit on such accounts.

Under the Wakalah contract, clients give funds to the bank that serve as their investment manager. The bank charges a predetermined fee for its managerial services. The profit on to the fund after deducting such a fee. On the assets side, the bank uses a number of financial instruments none of which involves interest.