Islamic banking in Nigeria, explained

Islamic banking is a type of financial system which can be generally summarized as non-interest banking.

Conventional banks make a large chunk of their money from giving loans to customers for a specified period and charging interest on it when it is time to pay back. In Islamic banking, on the other hand, there are no interests on loans, and profits or losses are shared between the bank and the customer at an agreed-upon rate.

There are two fundamental principles of Islamic banking which are; the sharing of profit and loss and the prohibition of the collection and payment of interest by lenders and investors.

Popular terms in Islamic banking

Musharakah is a profit-and-loss sharing partnership and the most authentic form of Islamic Financing. It is a contract of joint partnership where two or more partners provide capital to finance a project or own real estate or movable assets, either on a permanent or diminishing basis. Partners in musharakah have a right to take part in management; they seem to bear the greatest risk among all Islamic financing modes with the potential for earning the highest reward. However, whereas profits are distributed according to pre-agreed ratios, losses are shared in proportion to capital contribution.

Murabaḥ ah is a popular Sharia-compliant sale transaction mostly used in trade and asset financing. The bank purchases the goods and delivers them to the customer, deferring payment to a date agreed by the two parties. The expected return on murabaḥ-ah is usually aligned with interest payments on conventional loans, creating a similarity between murabaḥ-ah sales and asset-backed loans. The difference between this tool and conventional loans is that banks stick to the interest rates set by the CBN – rates that can be increased anytime before the maturity of the loan. Murabaḥ-ah rates on the other hand remain the same until the maturity of the loan.

Mudarabah is a profit-sharing and loss-bearing contract where one party supplies funding (capital owner) and the other provides effort and management expertise (manager) with a view to generating a profit. The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah

Ijarah is a contract of sale of the right to use an asset for a period of time. It is essentially a lease contract, whereby the lessor must own the leased asset for the entire lease period. Since ownership remains with the lessor, the asset can be repossessed in case of nonpayment by the lessee. However, the lessor is also responsible for asset maintenance, unless damage to the leased asset results from lessee negligence. This element of risk is required for making ijarah payments permissible.

Salam is another mode of financing in Islamic Finance. It is a sale where the seller undertakes to supply some specific goods to the buyer at a future date is specified in exchange of an advanced price fully paid at spot. This mode of financing is used to finance the agricultural sector.

Istisna is another mode of financing where the commodity involved is manufactured to the specifications of the purchaser. This is widely used in the housing finance sector, where the client seeks finance for the construction of a house. The financier may undertake to construct the house on a specified land either belonging to the client or purchased by the financier, on the basis of Istisna with payment fixed in whatever manner the parties may wish.

Sukuk is the Islamic equivalent of bonds and they are similar to asset-backed securities. Whereas a conventional bond is a promise to repay a loan, Sukuk constitutes partial ownership in receivables In practice, Islamic finance often involves structuring transactions in a manner that closely mimics conventional finance insofar as a periodic rate of return is provided. In certain types of Sukuk instruments, a predetermined rate of return is often paid to the investor; this rate is based on the expected return of the underlying assets that collateralize the Sukuk. In the case of debt-like financing by Islamic banks, interest is not charged; instead, debtors will provide predetermined and periodic payments to the bank, based on the expected profit that would accrue to the underlying asset (in the case of a capital investment), or on the rent that might be charged for the use of the underlying asset (in the case of a home or car loan)

Musharakah and mudarabah can be used for short, medium and long-term project-financing, import-financing, export financing, working capital financing and financing of single transactions. Diminishing musharakah can be used for large fixed assets such as houses, transport, machinery, etc. Murabaha can be used for purchases of goods needed by the bank’s clients. Salam is useful for financing farmers, trading commodities for the public and private sectors and other purchases of measurable and countable things. But it must be kept in mind that buyback and rollover modes may not be used, because they are seen as a back door to interest.

FAQs on Islamic banking in Nigeria