Demystifying the Islamic Banking Concept

Historically, Islamic banking was one of the efforts the colonised Islamic countries evolved in order to build up their economies as much as possible, in accordance with Islamic faith in the face of discriminating foreign banks. Although the concept of Islamic finance can be traced back about 1,400 years, its recent history can be dated to the 1970s when Islamic banks in Saudi Arabia and the United Arab Emirates were launched. Bahrain and Malaysia emerged as centres of excellence in the 1990s. It is now estimated that worldwide around US $1 trillion of assets are managed under the rules of Islamic finance.

In Islamic countries their laws had and have to be adjusted to accommodate Islamic banking. But in non-Islamic countries where such a bank is established, it is the bank that adjusts to the existing laws.

Non-interest banking or Islamic finance rests on the application of Islamic law, or Shariah whose primary sources are the Qur’an and the sayings of Prophet Mohammed, and very much in the context of Islam emphasizes justice and partnership.

The main principles of Islamic finance are that:

  • Wealth must be generated from legitimate trade and asset- based investment. (The use of money for the purpose of making money is expressly forbidden).
  • Investment should also have a social and an ethical benefit to wider society beyond pure return.
  • Risk should be shared.
  • All harmful activities (Haram) should be avoided.
     

Islamic finance specifically prohibits the following:

  1. Charging and receiving of interest (riba).
  2. Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or anything else that the Sharia considers unlawful or undesirable (haram).
  3. Uncertainty where transactions involve speculations or extreme risk.
  4. Uncertainty about the subject matter or terms of contract (this includes a prohibition on selling something one does not own).

What then is permitted under Islamic finance? As mentioned above, the receipt of interest is not permitted under Shariah. Therefore, when Islamic banks provide finance they must earn their profits by other means. This can be by profit-share relating to the assets in which the finance is invested, or can be by a fee earned by the bank for services provided.

There are a number of Islamic financial instruments (products). These include but are not limited to:

  1. Murabaha: is a form of trade credit for asset acquisition that avoids the payment of interest. Instead, the bank buys the item and then sells it on to the customer on deferred basis at a price that includes an agreed mark up for profit. Here, mark up is fixed in advance and does not change even if the customer does not take the goods within the time agreed in the contract.
  2. Ijara: is a form of lease agreement whereby the bank buys an item for a customer and then leases it back over a specified period at an agreed amount. Ownership of the leased asset remains with the lessor bank, which will seek to recover the capital cost of the equipment plus a profit margin out of the rental payable. Emirates airline regularly uses this form of finance to finance its expansion.
  3. Mudaraba: is essentially like equity finance in which the bank and the customer share any profits. The bank will provide the capital, and the borrower, using their skills and knowledge, will invest the capital. Profits will be shared according to the finance agreement, but as with equity finance there is no certainty that there will ever be any profits, nor is there certainty that the capital will ever be recovered.
  4. Musharaka: is a joint venture or partnership between two parties. Both parties provide capital towards the financing of projects and both parties share the profits in agreed proportions.
  5. Sukuk: is a kind of debt finance. A conventional, non-Islamic bond or debenture is a simple debt, and the bondholder’s return for  providing capital to the bond issuer takes the form  of interest. Islamic bonds, or sukuk, cannot bear interest. So that the sukuk are Shariah-compliant, the sukuk holders must have  a proprietary interest in the assets which are being  financed. The sukuk  holders’ return for providing finance is a share of the income generated by the assets.

THE SHARIA BOARD

The Sharia board is a key part of an Islamic financial institution just like the board of any financial institution. It has the responsibility for ensuring that all products and services offered by that institution are compliant with the principles of Sharia law. Boards are made up of a committee of Islamic Scholars and different institutions can have different boards.

The last statement above is what drew the irking of religious leaders and other critics of Islamic banking. The Central Bank of Nigeria (CBN) however, has removed that provision to suite the Nigerian case.

CHALLENGES

The challenges even in openly acknowledged Islamic countries with Islamic banking include lack of basic principles on how to implement profit/loss sharing for existing businesses that only require ad hoc working capital, long-term projects and personal/consumer loans. Experts in different types of businesses are required to evaluate and monitor the debtors’ activities with respect to profit or loss. Islamic banks shun small scale businesses as per the difficulty of monitoring businesses which on their own usually lack records of their activities. Also small businesses do not want their activities hundred percent in the public domain through the bank up to tax authorities; even publicly quoted companies have reluctance to display their nakedness to all in spite of IFRS requirements. This explains the excess liquidity in the bank for small scale business. Long term project is also unsuitable for Islamic bank as there is a lack of robust project evaluation models that will not use interest element. This leaves the bank inclined dominantly towards short term financing for trade.

CONCLUSION

Whether we call it Non-Interest Banking or Islamic Banking is a matter of nomenclature. It does not change the basic fundamental concept of Islamic Banking. Countries have adopted this form of banking and it is working for them. HSBC in the UK has it as a product. Saudi Arabia, UAE, South Africa, Malaysia (where we copied the microfinance banking model) among others, have all adopted Non-Interest Banking and it is working for them. It is estimated that over US$1 trillion worth of assets is controlled by Non-Interest Banking.

Advocates of Islamic finance claim that it avoided much of the recent financial turmoil because of its prohibition on speculation and uncertainty, and its emphasis on risk-sharing and justice. That does not mean that the system is free from risk (nothing is anyway), but if you are more exposed to risk you are likely to behave more prudently.

On a final note Islamic finance or Non-Interest Banking is a financial product like any other and should not be seen as the solution to the problems in our financial system as it  creates its own peculiar problems.

Reference: Ken Garret, March 2011. Freelance author and lecturer.

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About Ifemezue Uma

Ifemezue Uma is a Civil Engineer by training, a financial analyst by practice and currently a government employee practicing as an engineer. Ifemezue has a burning desire to project a more positive image of Africa through his writing, as well as reflecting on random thoughts and any topic of interest. You can find him on Twitter @ifeuma and LinkedIn: https://www.linkedin.com/in/ifemezueuma/
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One Response to Demystifying the Islamic Banking Concept

  1. Bolade says:

    An Islamic bank would work in a puritarian society where there is a critical mass of people with intergrity . Is it not an irony that Nigerian breweries sell more alcoholic drinks in the North despite the preponderance of shariah faithfulls .Whether interest bearing or profit sharing will people take money ,use it for intended purpose,make profit and honour their obligation in the ordinary course of business Nigeria. I doubt it with the level of poverty , inequality ,social injustice ,economic volatility and lack of confidence in the nation . When we read the holy books we forget that we we have same faiths as the Arabs but we dont have the same resource endowmment and small manageable population. We must never forget that this is a 156million people nation on a vast land area of 91million hectares. How do we compare with Libya ,Saudi Arabia ,Kuwait etc

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