Oct 11, 20236 min read

ISLAMIC BANKING AT A GLANCE

" Islamic Finance = Finance with the remembrance of God” - Amanah Advisors

As a Banker and Islamic School Teacher, I’ve always been fascinated by Islamic banking and finance, and how it integrates into the modern day banking and finance globally.

Recently, I was granted a virtual internship opportunity by AlHuda Centre of Islamic Banking and Economics (CIBE), an Islamic think-tank and Islamic Finance consultancy based in Dubai UAE . After a rigorous two months of Article Writing, Development of Industry Linkages with concerned Market, Data Collection & Communication, free seminars in Educational Institutes, Forums, Associations, Religious Organizations, Establishment of Strategic Partnership linkages, Promoting Distance Learning Program and Al-Huda CIBE Services, Visit to the Financial Industry, Weekly Reports and Fortnightly Meeting, and a Final Internship Report. I was certified.

Participation flier from AlHuda CIBE Farooq Gajo

Hence I decided to write a 5-minute read article on Islamic Banking and economics to share with you my readers ( I know it’s been long I posted here, I promise to do better!)

What is Banking?

Generally, Banking is a business of intermediation, in which money is taken from areas of surplus and borrowed to areas of deficit with the aim of rejuvenating the economy.

In rejuvenating the economy, a lot happens and that is where profit (resulting from charges, commissions, fees, interest or equity participation) and loss (in case of default or non-profitability) are made, ultimately the approach a bank takes here is what determines if it is Islamic or not.

What is Islamic Banking?

Islamic banking is grounded in the tenets of the Islamic faith as they relate to commercial transactions. The principles of Islamic banking are derived from the Quran, which is the central religious text of Islam.

Beginning in the 1960s, the first modern experiment with Islamic banking can be traced to the establishment of the Mit Ghamr Savings Bank in Egypt in 1963. Islamic banking resurfaced in the modern world, and since 1975, many new interest-free banks have been established. Islamic banking also referred to as Islamic finance or Shariah-compliant finance, refers to finance or banking activities that adhere to Shariah (Islamic law). The rules that govern commercial transactions in Islamic banking are referred to as fiqh al-muamalat.

Two fundamental principles of Islamic banking are the sharing of profit and loss and the prohibition of the collection and payment of interest by lenders and investors.

Islamic banks make a profit through equity contribution, which requires a borrower to give the bank a share in their profits rather than paying interest. There are more than 560 Islamic banks and over 1,900 mutual funds around the world that comply with Islamic principles. Some conventional banks have windows or sections that provide designated Islamic banking services to their customers.

Riba (i.e. Interest)

Riba is mentioned and condemned in several different verses in the Qur’an (3:130, 4:161, 30:39 and perhaps most commonly in 2:275-2:280).

يَـٰٓأَيُّهَا ٱلَّذِينَ ءَامَنُوا۟ لَا تَأْكُلُوا۟ ٱلرِّبَوٰٓا۟ أَضْعَـٰفًۭا مُّضَـٰعَفَةًۭ ۖ وَٱتَّقُوا۟ ٱللَّهَ لَعَلَّكُمْ تُفْلِحُونَ ١٣

Translation:

O believers! Do not consume interest, multiplying it many times over. And be mindful of Allah, so you may prosper. Q3:130

Riba is an Arabic word that means “to increase” or “to exceed” and is commonly used in reference to unequal exchanges or charges and fees for borrowing. Interest is deemed riba, or an unjust, exploitative gain, and such practice is forbidden under Islamic law. In Islamic finance, riba refers to interest charged on loans or deposits. Religious practice forbids riba, even at low interest rates, as both illegal and unethical or usurious.

Islam consider that Riba is not only an oppressive practice, it also involves exploiting those in need. A fundamental part of being a Muslim involves that those who have wealth need to assist those that do not.

Islamic banking has provided several workarounds to accommodate financial transactions without charging riba (i.e. interest).

Examples of Islamic banking products?

Some of these include Mudharabah (profit sharing),

Wadiah (safekeeping),

Musharakah (joint venture),

Murabahah (cost plus finance),

Ijar (leasing),

Hawala (an international fund transfer system),

Takaful (Islamic insurance),

and Sukuk (Islamic bonds).

Key Differences between Islamic and Conventional Banking

One of the primary differences between conventional banking systems and Islamic banking is that Islamic banking prohibits usury (Usury is the act of lending money at an interest rate that is considered unreasonably high or that is higher than the rate permitted by law) and speculation (taking positions on the market without any underlying reason or fundamental analysis, based on chance, and not on actual economic activity). Shariah strictly prohibits any form of speculation or gambling, which is referred to as maisir. When more information or guidance is necessary, Islamic bankers turn to learned scholars or use independent reasoning based on scholarship and customary practices. Shariah prohibits taking interest on loans. In addition, any investments involving items or substances that are prohibited in the Quran—including alcohol, gambling, and pork—are also prohibited.

In this way, Islamic banking can be considered a culturally distinct form of ethical investing. To earn money without the typical practice of charging interest, Islamic banks use equity contribution systems (Murabaha). Equity contribution means if a bank lends money to a business, the business will pay back the loan without interest and instead give the bank a share in its profits. If the business defaults or doesn’t earn a profit, then the bank also doesn’t benefit. During the years of Mit-Ghamr project operations, the bank exercised a great deal of caution, only approving about 40% of its business loan applications. However, in economically good times, the bank’s default ratio was said to be zero

In general, Islamic banking institutions tend to be more risk-averse in their investment practices. As a result, they typically avoid business that could be associated with economic bubbles.

Murabaha (Cost-Plus Financing)

Murabaha, also referred to as cost-plus financing, is the Islamic financing structure in which the seller and buyer agree to the cost and markup of an asset. The markup takes place of interest, which is illegal in Islamic law. As such, murabaha is not an interest-bearing loan (qardh ribawi) but is an acceptable form of credit sale under Islamic law. As with a rent-to-own arrangement, the purchaser does not become the true owner until the loan is fully paid. In Islamic finance, murabaha financing is used in place of interest-bearing loans.

Certificate of Completion_ Farooq_Gajo

Many argue that this is simply another method of charging interest. However, the difference lies in the structure of the contract. In a murabaha contract for sale, the bank buys an asset and then sells the asset back to the client with a profit charge. This type of transaction is halal or valid, according to Islamic Sharia.

Additional charges may not be imposed after a murabaha due date, which makes murabaha default an increasing concern for Islamic banks. Many banks believe defaulters should be blacklisted and not allowed future loans from any Islamic bank as a method of decreasing murabaha default. Even if it is not expressly mentioned in the loan agreement, this arrangement is permissible in Sharia. If a debtor is facing a genuine hardship and cannot repay a loan on time, respite may be given as described in the Quran. However, the government may take action in cases of willful default. Defaults under murabaha arrangements have become a problem for companies operating under Islamic law and there has been no clear consensus on how to deal with them. Further research has shown that Islamic banks may require collateral to protect themselves against possible default by borrower. The idea of collateral is derived from the concept of Ar-Rahn (pawning). Ar-Rahn means pledging of an asset or title as a security to obtain loan or financing from a pawnshop.

Ignorance and lack of awareness about Islamic Finance has fueled a lot of resistance to its adoption, As of now, Jaiz Bank, TAJ Bank, and Lotus Bank stand as the sources of Islamic banking in Nigeria.

Key Takeaways:

Islamic banking and finance is the kind of banking practice that strictly adhere to the Sharia and the teachings of the Quran.
An important principle of Islamic finance is that banks do not collect interests. Instead, they share profits and even losses. Also, while trading, banks go for non-speculative and risk-averse investments.

If you are interested in reading further about this topic, below are some useful resources.