While Islamic financial institutions are more like ‘universal banks’ that undertake various kinds of fund-based and fee-based operations, the characteristic that sets them apart is the need for Shariah compliance and promotion of Islamic values.

An Islamic Financial Institution (IFI) is an organization that performs all the typical functions of financial intermediation while retaining its Islamic character. It undertakes both (i) mobilization of funds from savings-surplus economic units (usually the household sector) through an array of financial assets (deposit products) and (ii) canalization of funds into profitable projects floated and operated by savings-deficit economic units (usually the corporate and government sectors). While conventional banking uses the interest rate mechanism to perform its task of financial intermediation, Islamic banking relies on profit/loss sharing for the purposes of financial intermediation. Several models have been suggested for the structure of an Islamic financial institution.

The first model is based on mudaraba and is commonly referred to as the “two-tier mudaraba” model. The basic concept of this model as originally developed by Khan (1986) is that both funds mobilization and funds utilization are on the basis of profit sharing between the investor (depositor), the bank and the entrepreneur. The first-tier mudaraba contract is between the investor and the bank, where investors act as suppliers of funds to be invested by the bank on their behalf as mudarib; the investors share in the profits earned by the bank’s business related to the investors’ investments. Funds are placed with the bank in an investment account. The liabilities and equity side of the bank’s balance sheet, thus, shows the deposits accepted on a mudaraba basis. Such profit-sharing investment deposits are not liabilities (the capital is not guaranteed and they incur losses if the bank incurs losses so), but are a form of limited-term, non-voting equity. The secondtier represents the mudaraba contract between the bank as a supplier of funds and the entrepreneurs who are seeking funds and have agreed to share profits with the bank according to a certain percentage stipulated in the contract. In this model, in addition to investment deposits, banks will accept demand deposits that yield no returns and are repayable on demand at par value and are treated as liabilities.

The Analyst Magazine, Islamic Financial Institutions, Shariah Compliance, Financial Assets, Two-Tier Mudaraba Model, Islamic Banking, Islamic Financial Institutions Services, Mudaraba Deposits, Demand Deposits, Savings Surplus Units, Islamic Commercial Banks, Sukuk, Islamic Law.