Islam is a religion which encompasses the entire life its adherents. The source of all laws regulating the Islamic way of life flows from the Quran and Shariah. That includes the business and commercial aspects of the Islamic community. In fact, Mecca and Medina, the two most sacred places of Islam had always been flourishing centers of trade. The banking as we know it today d id not exist then. It is a western institution which came into being after the industrial revolution in Europe. Certain elements of modern banking did exist at time when Islam was revolutionizing the Arab region. Interest is central element of modern banking which is prohibited in Islam. It is known as Riba(interest) the acceptance and payment of which is considered un-Islamic. These principles did well as the economy at the time was prosperous.

The Islamic banking grew out of the need of the Muslims to evolve a  system of finance which while fulfilling all the needs of the business and people yet remains within the principles of Shariah. It came into being during the late 20th century. During last three decades, a large number of Islamic banks have come in all parts of the world catering to the financing needs of the Muslims. Though the name is a bit of misnomer as the Islamic banking is not exclusively for Muslims. It is same as conventional banking  but functions in accordance with the injunctions of the Shariah and Quran.

During the colonial times, the Muslims came in contact with the western banking institutions. The Muslims faced a banking system which was value-neutral. They had a choice to accept this or evolve a Shariah-compliant banking  institution. There was debate going on in 19th century amongst the scholars of Islam whether interest(Riba) referred to loans for consumption or those undertaken for commercial purposes. Such proposals were rejected as the does not distinguish between different kinds of loans.

In the sixties, the Islamic Economists started working on devising ways of establishing commercial banking compliant with Shariah principles. Such an experiment was successful in rural Egypt which functioned on zero-interest policy operating three types of accounts,i.e.,saving accounts, Zakat accounts and investment accounts. the project was later terminated but had shown Islamic banking can become reality.

The oil boom and oil price rationalization during seventies gave further fillip to the establishment of modern Islamic banking. Islamic banking is based on the principle of Mudarabah(Islamic Way, Profit-Loss-Sharing). It also stipulates another rule no reward without risk-bearing. Mudarabahah can be best illustrated by the example of two persons one of whom has got the capital and the other has the managerial and entrepreneurial skills. They join hands pooling their respective resources and agreeing to share profit and bear loss in accordance with the contract they signed before starting the enterprise. So the depositors take a percentage of profit the bank generates from their capital whereas the entrepreneurs shares the profits generated from the capital of the bank.