In general, there is a low level of public awareness of what Islamic banking is, especially in countries where this is a new introduction. Even in Islamic countries where Islamic banking has been operating for decades, the level of knowledge amongst the public is still low.
In this article, I hope to provide some introduction to the concept of Islamic banking, with specific reference to Nigeria. I have tried to keep this article quite concise, and where an aspect needs further information, the reader is encourage to take a look at some article on here that explain further in more detail.
1) What is Islamic Banking?
It is simply a banking infrastructure that is aligned with the Muslim faith. Certain things are prohibited (like paying and receiving interest), and there are certain industries that Muslims can not invest in (such as gambling, alcohol, pork and related products and so on).
2) What are the main Principles underlying Islamic banking?
In all cases, the principles are created so that all parties are treated fairly and that there is an element of justice and transparency in commercial activities.
The main one is the ban on paying and receiving interest. That applies to banks as well as the customers and businesses. In addition, forms of gambling are prohibited, and this applies to speculation in the finance sector. So if an investment is seen as pure speculation, then it will be problematic. That is why the emphasis is on investment and trading of real assets in the real economy. Paper assets are permissible as long as they represent investment into and ownership of real assets, such as stocks and shares.
It is permissible to have Islamic debt. For instance you can give an interest-free loan to a customer. This does not really happen in practice, as I will explain below. But it is possible. You give a loan of, say, £100 and you only ask for that £100 back. This is permissible and it brings a reward from God, as it is referred to Qard al Hassan, or a beneficial loan.
Foreign exchange (FX) transactions are permissible, but they are restricted. An FX spot transaction is permitted, whereby you buy one currency and pay for it in a second currency. However, FX options and FX forwards are generally not permitted.
It is not permissible to bring into a contract a level of ambiguity that can impact the proper execution of that contract. This can be due to the contract being too vague (eg I will sell a red car to you for £1,000 leaves the possibility of the seller substituting a red car worth only £500) – this is called Gharar.
Another form of uncertainty that is not permitted relates to forward transactions. If I agree to buy a car from you for £1,000, that is fine. I can pay you immediately or in the future. I can pay you immediately and you can deliver the car to me in the future. Note how at least one of the two key items (the car and the cash) must be delivered immediately. It is not permissible to delay both. For example, if I agree to buy the car from you, and we agree that I will pay you in one week’s time, and you will deliver the car to me also in one week’s time – this is a forward transaction and this is impermissible. This is because neither of us can guarantee that we will able to fulfil our commitments in the future, hence this brings a level of Gharar that makes the contract void.
3) Can non-Muslims use Islamic banking?
Sure, it is open to everyone. You can see it as one type or moral or ethical form of banking and investing. For example, in Malaysia, there are many customers of Islamic banks who are non-Muslim. They choose an Islamic bank because of the products on offer, the service, and the pricing. An Islamic bank is a product and service provider, just like conventional banks. They compete, side by side, for the business of non-Muslims.
4) Does calling it Islamic banking have a stigma attached?
Maybe. Using Islamic in the title may apply this is only for Muslims, and it may apply that there is some form of exclusion to non-Muslims. This simply is not true. But the implication may exist. There have been some attempts to called Interest Free Banking, and in Turkey it is called Participation Banking. Maybe this is something for the industry to think about.
5) What do Islamic banks actually do?
Well, they do pretty much what you expect from any bank. They let you place deposits with them, they provide loans to retail customers (car finance, home finance, personal loans), they offer credit cards. They offer banking services to businesses, as well as loans to businesses too. Some Islamic banks have investment products too, and they may operate some investment funds. They do a lot of the things your normal non-Islamic banks do (these are also referred to as conventional banks). Here is a snapshot from the website of Jaiz Bank, which is an Islamic bank operating in Nigeria:
There is nothing new here (except the word “Ijara” which I explain in a later section below – essentially it is a form of car leasing, or car financing).
Current accounts
They all offer current accounts. In the same way that most conventional banks do not pay interest on current accounts, nor do Islamic banks. However, if you open a term deposit account, or a savings account, you will receive something from the Islamic bank. See below.
Term deposits and savings accounts.
If you are willing to place your funds for a fixed term (for example, 6 months, one year and so on) then you will get some return from the Islamic bank. They will show you the rates that they deliver.
For example, Jaiz Bank offers a savings account on the basis of a contractual relationship called Mudarabah. This means that the customer’s funds are paid to the bank, and then something unusual happens. The bank uses your funds to invest in certain activities and operations. These will be Shariah compliant. The bank will earn profits from these activities and then this profit is shared between you and the bank. Their website informs us that you will keep 30% of these profits, and the banks keeps 70% of these profits.
I know you will then ask “What happens if the bank makes no profits, or if the bank actually loses some of my money?”. I address that later below.
Loan products
Car Finance, Murabaha
Jaiz bank offers car finance, on a contract called a Murabaha contract. What it means is that once you identify a car you want to buy, you approach the bank and make an application for financing. Once that is successful, the bank will actually buy the car from the dealer or seller, and then the bank will sell the car to you, for a price higher than the car retail price. You pay the bank back in regular monthly instalments. Some banks provide an online calculator to let you work our what your monthly repayments will be, but I could not find this on ths Jaiz bank website. However,we can find such a calculator here:
https://www.kfh.com/en/home/Personal/Tools-services/calculators/finance-calculator.html
This is for Kuwait Finance House, the second largest Islamic bank in the world.
Car Finance, Ijara
There is another way that an Islamic bank can offer car financing, called an Ijara contract. However, when I click on this link on the Jaiz Bank website, it takes me the Murabaha car finance product, which I describe above.
I can explain how a car ijarah product works. You identify the car you wish to purchase, and then the bank purchases that car from the dealer or seller. Then the bank leases the car to you, rather than sell it to you (as above in Car Murabaha). You then lease the car from the bank for 3 years, 5 years, whatever was agreed. At the end of the leasing period, what normally happens is that the car ownership is transferred to you, and the car is then yours. During the leasing period, the car belongs to the bank.
Finance for Businesses
Jaiz Bank offers a loan product to help a business buy inventory or raw materials. This works on a similar basis to Car Murabaha described above. You identify what you want to buy, and then the bank purchases it from the seller, then the bank sells it to you, and you repay the bank in instalments. The price you pay to the bank is higher than the cost price of the material, and this is the profit of Jaiz bank.
It is possible to obtain a loan from an Islamic bank without identifying or specifying that you want o buy a certain product. This contract will often be a Commodity Murabaha contract. It will take some time to explain, but other articles on here explain that in some detail.
Trade Finance
Jaiz Bank offers financing to clients to support imports and exports. For importers, the bank issues a Letter of Credit (LC) in favour of the exporter, on behalf of the importer. The bank is then committed to paying the exporter upon presentation of the relevant documentation. The bank purchases the imported material in its own name first, and then these goods are sold to the importer.
Credit Cards
Islamic banks do indeed offer credit cards, but I could not find this facility on the website of Jaiz Bank, There are 2 or 3 different methods that banks use so that they do not charge interest. One way is to charge a monthly fee based on the credit amount. In that case, the customer pays the monthly fee regardless of the amount of credit actually utilised.
6) Do Islamic banks give free loans?
No, they do not. Sure, they can not charge interest, but they make a profit from any financing that they provide. The manner in which they make this profit depends on the contract. A popular contract is Murabaha (where the bank makes profit due to selling the item to you) and also Ijara (where the customer leases the car or home from the bank).
7) How do Islamic banks make money? Is this model sustainable?
They make money that is not interest, but it is profit, either via trading or some kind of investment activity. And, yes this model is sustainable. Islamic banks have been operating for decades, and the two largest banks in the world are Al Rajhi in Saudi Arabia, and Kuwait Finance House (Kuwait). They made profits of $2.7 billion and almost $750mn respectively for 2018. That is not bad!
8) How do Islamic banks choose investments?
Ok, so we have to distinguish between what kind of investments we are talking about. When you place your money on a Mudarabah deposit with a bank (this is explained above) then the bank is committed to investing your money, What does it do?
On their website, Jaiz Bank says:
“invests the depositors’ monies into financially profitable, socially desirable and commercially viable business ventures which are legal and Shariah compliant.”
This sounds great! However, if you have a wonderful and ethical business idea, I would not suggest you ask Jaiz bank to invest in it with depositor’s money. They will say no. Why?
Because the depositor will not accept this risk. Look at it this way, if you place a savings deposit with the bank, do you want your money to be used to invest in local businesses?
Well, if you say yes, then be prepared that sometimes you will lose money.
Are you prepared to accept that? Maybe not!
So, the bank needs to protect the depositor’s funds. I will discuss how it does that in the section below.
The other area where the bank may make investments is when it operates an Islamic fund for their customers to take part in. In that case the bank will inform investors as to what the fund will do. The most common kind of fund is an equity fund, which will invest in the shares of local or international companies.
9) Protection for deposits
Ok, when you place a deposit at a normal conventional bank, they are legally obliged to return your deposit (along with any interest that is due). If they fail to do this, they are in breach of contract, and have failed in the requirements place on them by the banking regulator. However, the whole contractual relationship in Islamic banking is different.
So, the issue of protection of deposits is a crucial one.
Now, the answer to this depends on the type of contract used. Jaiz Bank use a Mudarabah contract – this means they act like an investment manager, and their aim is to invest your funds and make profit.
The other contractual form is based on Commodity Murabaha, which Jaiz Bank appear not to use (I could not see any reference to this on their website). From a customer’s point of view, the Murabaha contract is more secure. The bank is legally obliged to return your deposit and an agreed profit to you. If it fails, this is breach of contract, just like a conventional bank.
For a Mudarabah contract, the bank can NOT guarantee your deposit. It can not say that, whatever happens with the investments in makes on your behalf with your money, that they guarantee you will get 100% of your deposit back, or all the profit that they aim to make for you. This simply can not be guaranteed, because of restrictions in Islamic commercial law for Mudarabah contracts. As investor, you must bear this risk of loss.
Of course, no one wants the risk of losing their deposit. So, in practice, the banks do two things to mitigate this risk.
First, the bank is very careful how it invests your money. It does NOT invest your deposit into local businesses, no matter how wonderful, ethical and attractive they may be. What they do is utilise your deposits within the existing business of the bank itself. They use it to fund the regular business activities of the bank. To get an idea of this, we need to look at the financial statements of Jaiz bank.
I have done this for you, in my selfless and noble quest to answer your questions!
In their annual report for 2017 (I guess the 2018 report is not yet released), I took a look at their “Statement of Financial Position” on page 64. What we need to do is look at the assets of the bank. When you place a deposit with the bank, this is an asset for you but a liability for the bank. We can the following in the list of liabilities of the bank:
And the first line is “Customer Current Deposit” – so the deposit you place with the bank is listed as a liability for the bank.
Ok, so now it invests your deposit into their assets, which look like this
So, your deposit is invested somewhere in the above list. The bank will never be able to tell you exactly which type of asset your deposit is invested into, because it pools together all the customer deposits and then uses this single pool to fund its liabilities. However, one thing to note is that all the assets should be earning a profit. So that is how your deposit earns a profit, because the underlying assets of the bank (which your deposit is invested into) earn profits.
Now, the bank manages all these assets, and they try their very hardest to make profit from these assets, and certainly to avoid any losses. This is the first way the bank mitigates the risk of loss of your deposit.
Second method of risk mitigation
Ok, this second method is actually more important than the first. Let us imagine that the bank is offering to deliver a profit to you of 3% on the savings account. Let’s say you deposit 1mn NGN. So the bank is saying that after 1 year, you SHOULD receive a profit amount of NGN 30,000 after one year. So the bank will take your money, and invest it into the assets we have listed above. Some assets may earn annual profits of 4%, some 7%, some 2% and maybe some earn nothing, or indeed make a loss. So it is the bank’s job to ensure your funds earn 3%.
What if things go wrong, and your funds only earn 1% in reality. Does the bank turn around and say “Sorry, my dear valued customer, you know times are tough, so we are only able to pay you NGN 10,000 instead of the 30,000 that we anticipated. We know you will understand.”
This is not acceptable to customers, is it. So what happens, in reality is that the bank will say this “We anticipated a profit of NGN 30,000 on your account, and here it is.”
Yes, they will just pay you the agree profit rate of 3%. This is market practice.
Even though the Mudarabah contract permits the bank to deliver less profit than the agreed 3%, in practice it will just deliver the 3%. The main reason for this is market forces – if the bank fails to pay the anticipated profit rate, then customers will simply leave the bank.
10) Protection of the actual deposit amount
Ok, so the above covers the profit amount, what about the actual deposit amount being protected. In a Murabaha contract, the capital is certainly protected – if the bank fails to deliver back to you your deposit of NGN 1m and your profit of 3% or NGN 30,000, then this is a breach of their contract. You have the same remedy as if any bank failed to return your deposit back.
In a Mudarabah contract, you have two levels of protection. As stated above, the Mudarabah contract can NOT provide this protection – as the investor, you MUST bear risk of loss. In practice this risk is mitigated.
This first mitigant is market forces – as mentioned above, if the bank fails to return your deposit, then customers will leave the bank. The bank will have a bigger problem than it’s inability to pay back to you your NGN 1m deposit in full. The reputational risk of the bank is worth much more than your deposit.
Secondly, the banking regulator would have something to say about the fact that an Islamic bank fails to deliver the deposit back to the customer. In Nigeria, you have the Nigeria Deposit Insurance Corporation (NDIC), which plays the role of protecting deposits of customers at banks. Jaiz Bank, even though it is an Islamic bank, operates within this infrastructure.
From a statement by NDIC on a paper on their website :
“The NDIC Boss informed the team that the Corporation had developed a non-interest banking deposit insurance fund framework in May 2015 which is designed to create a level playing field and provide deposit protection for depositors involved in non-interest banking and protect them against any possible losses.”
And, in addition, Jaiz Bank appears to pay some form of insurance for deposit protection, as this is referreed to in their Account Opening Terms and Conditions form:
“In determining the Net Distributable Profits, the regulatory Deposit Insurance Premium (in future, Deposit Takaful contribution) shall be deducted as expense.”
So, in practice, I would expect customer deposits to be part of this scheme. However, it is best, of course, to check directly with the bank.
11) How can Islamic banks support my business?
Well, an Islamic bank can offer the normal operation of business account and credit, as a conventional bank does. I have described above some forms of loans and credit that are provided.
And remember, you do not need to be a Muslim to benefit from this! Anyone can qualify for services from an Islamic bank.
12) How can Islamic banking benefit Nigeria
Firstly, it provides a clear benefit for Muslims that they can receive banking services that are aligned with their religion. This is important.
Remember, this service is not only open to Muslims – anyone can be the customer of an Islamic bank. Any corporate can be a customer. Not only Muslims.
The introduction of Islamic banks also helps to provide competition in the banking sector. While Islamic banking is still young in Nigeria, the level of competition from a single Islamic bank may be limited. However, as that bank matures, and maybe as other banks enter the market, they will be competing with conventional banks for customers, and you would espect to see this result in better pricing and service across the banking market.
Another key way Islamic banking helps Nigeria is the ability to raise capital from Islamic investors. A Sukuk is an Islamic version of a bond.
There is a good article explaining Sukuk here:
And, of course, the second book in my series Islamic Banking in Practice, focuses solely on Sukuk.
Osun State has issued a sukuk for NGN 10bn in 2013, and in 2017 the Nigerian government issued a Sukuk of size NGN 100bn.
Generally, the majority of investors in Sukuk are Islamic investors (Islamic banks, and funds). This means that without these Sukuk, these Islamic investors would not have invested these funds inwards into Nigeria. Proceeds of the Sukuk were deployed in the construction of 25 major federal roads and bridges across Nigeria’s six geopolitical zones, amongst other projects.
This is a clear benefit of Islamic banking to Nigeria, in my view.
13) Are Islamic banks regulated?
Absolutely. Jaiz Bank has a banking licence from the Central Bank of Nigeria. It is subject to the same level of scrutiny, governance and regulation as a conventional bank.
14) Summary
Even though Islamic banks operate in many different ways to conventional banks, their ultimate aims are very similar. They provide a safe place for deposits to place funds, and provide forms of credit and finance to their customers, personal and corporate. The contractual names are new (Murabaha, Mudarabah, Ijara, Sukuk and so on) however they are not very complicated in my view.
I am a big supporter of trying to spread knowledge amongst people, both Muslims and non Muslims about Islamic banking. This can help to reduce perceived differences giving rise dis-harmony amongst people of different faiths. In addition, the Islamic banking industry in general does a very bad job of helping to educate people. And, of course, their “education” is with the aim of getting our business, so understandably some of us do not trust fully what banks say all the time.
The above is still a brief summary of some key points. I discuss many related points in much more detail in my other articles that may benefit some readers.
I hope this has been useful to readers.
I’ll be sharing this with my team.