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Purpose The purpose of this paper is to outline the principles of and legal risk faced by Islamic banking and suggest necessary steps to mitigate them. Design/methodology/approach The paper examines ideal concept of Islamic banking and its practice. A range of publication is used, however the bulk of it concerns existing practices to provide practical insight on the subject rather than theoretical discourse. The paper is sorted into sections: Introduction, Islamic banking system, existing practices, legal risk and proposed reform. Findings Islamic banks face risks stemming from legal structure chosen due to the differences between principles of Shariah and law. While compliance to Shariah is paramount for Islamic banks, the law governing Islamic banking transactions may not necessarily give any consideration to Shariah . The paper elaborates legal risk exposed to parties to Islamic banking transactions encompassing the issues of the capacity of the parties to enter into a contract and its enforceability, uncertainty in laws, regulations, and legal actions pertaining to Shariah; as well as the legality of Islamic financial instruments. Research limitations/implications The paper reviews relevant laws and regulations related to Islamic banking, however no specific reference to any particular jurisdiction. Practical implications This paper is a source of information for those in the Islamic banking industry without legal background or lawyer new to it. Originality/value This paper touches upon a new area, the legal risk due to the divergence between the principle of Shariah and law. It offers practical insight into the legal aspect of Islamic banking operations.