What is Islamic banking?

Simply put, Islamic banking is banking that conforms to Shariah law. Islamic law prohibits charging interest as well as any usury (i.e., lending money at exorbitant or unlawful rates of interest). Therefore, interest cannot be charged on loans, nor can it be paid on savings. Typically Westerners who work in the Middle East deposit their salary into a local bank, but transfer any money they want to save (and earn interest on) to an offshore account.

To Western understanding, the idea of a bank that doesn't charge interest is rather shocking — though a bank that doesn't pay interest probably shocks few people these days! But Islamic banks are still banks, which means they also seek to make profits for their investors. It's just done differently.

As explained by the Institute of Islamic Banking and Insurance, "The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and-loss-sharing basis." For example, suppose a person wants to buy a vehicle and needs a loan. Rather than a Western-style loan where a person gets money which is paid back with interest, an option in Islamic banking is for the bank to buy the vehicle, sell it to the individual at a price higher than market value, and retain ownership on the vehicle until the money is paid. Or a corporate loan could be extended in which, in addition to repayment of the loan, the bank earns a share of whatever profit the company makes.

Finally, Islamic banking prohibits investing in companies that work in or with items that are unlawful in Islam, e.g., alcohol production, gambling establishments.