Why separating deposits matters in Islamic banking

By Rashid Aziz 

Recently, the Bank of Tanzania (BoT) officially issued new regulations governing banking operations that comply with principles which prohibit interest.

The regulations apply to fully-fledged interest-free (Islamic) banks as well as conventional banks that intend to offer such financial services through specialised units commonly known as Islamic windows.

The issuance of these regulations marks a historic milestone for Tanzania’s financial sector, as they establish a clear legal framework to guide the operations of banks offering this alternative model of financial services.

This framework is expected to help broaden public participation in the formal financial system.

One of the key requirements under the new regulations is the mandatory separation of funds belonging to customers using Islamic banking services from those used in conventional banking operations.

According to the guidelines, any bank or financial institution opting to offer interest-free services must provide a written undertaking to ensure that funds and accounts related to Islamic banking activities are kept completely separate from those of conventional banking.

In addition, such institutions are required to maintain separate accounting books and records for these operations. This professional arrangement, commonly referred to as ring-fencing, creates an operational barrier that prevents the commingling of funds within a bank offering both conventional and Islamic banking services. In my view, this requirement is critically important for several fundamental reasons.

First, if funds are mixed with those used in conventional banking systems, the Shariah legitimacy of all transactions conducted by the bank becomes questionable.

Islamic Shariah in financial matters does not only emphasise proper structuring of contracts and banking products, but also places close scrutiny on the origin of funds and how they are deployed in transactions.

For instance, a bank may design products and label them as Shariah-compliant. However, if funds collected through deposits from Islamic banking customers are mixed with non-compliant funds, those services lose their legal and ethical foundation.

Similarly, on the deposits side, when funds belonging to customers of Islamic windows are mixed with deposits arising from conventional banking activities, the operational identity of Islamic banking is undermined. This disrupts the core principles upon which interest-free financial services are founded, thereby casting doubt on the entire logic of Islamic banking—even if its products continue to be marketed as Shariah-compliant.

Second, separating these activities both financially and operationally helps to avoid operational challenges and makes monitoring banking activities easier.

This is because Islamic financial services are inherently linked to real assets (asset-based financing) or investments structured around profit-and-loss sharing (risk sharing), which differ fundamentally from conventional banking practices.

For example, financial products such as Murabaha, Musharakah or Mudarabah require specialised accounting procedures, controls and risk management frameworks.

Separating funds and accounting records enables banks to strengthen independent internal audits, enforce Shariah compliance, and facilitate effective oversight by regulators and customers alike.

Third, there is always a possibility that a bank may inadvertently earn income that is not Shariah-compliant, given that Islamic banking operates within a broader conventional financial environment.

Where there is a robust system for segregating accounts and funds of Islamic windows, it becomes easier for a bank to identify such income, which under Shariah principles must be channelled to charitable purposes.

This arrangement enhances transparency by clearly distinguishing between permissible funds and those that require purification, thereby preventing the retention of income that is not acceptable under Shariah.

Fourth, the separation of funds and accounts in interest-free banking is a vital tool for building customer confidence in Islamic banking operations.

To date, a segment of faith-conscious customers has remained sceptical about whether these institutions truly avoid interest in practice. Operational segregation therefore serves as an effective means of strengthening trust among banking service users.

Aziz is an Assistant Lecturer in the Department of Business Studies at Ardhi University.Email: [email protected]