October 20, 2020
Modern banking as we know it, has been around for a very long time. It started with prototype banks (merchants) that gave grain loans to farmers; and traders who sold goods between cities around 2000 BC in Assyria, India, and Sumeria. Non-Interest Banking (Islamic Banking) was born in the early twentieth century. The foundation for what would become modern Islamic Banking began with trade activities conducted in Mecca and Medina. Some of these activities continued even after Islam became rooted in Mecca.
Key Differences between Islamic and Traditional Banking Systems
The key difference between traditional finance and Islamic finance is that, under Sharia law, some of the activities used in conventional finance are strictly forbidden. Worthy of note is the non-acceptance or payment of interest (known as Riba) on money. The reason for this is simple; money is viewed purely as a medium of exchange in Islamic banking, unlike traditional banking where money is considered an asset.
Interest is believed to contribute to inequality and exploitation, so there are no real ‘loans’ in the Islamic banking system. Here is how loans work for Islamic finance; for the Islamic Bank to make a return on the money lent, it would have to acquire equity or shareholding in a non-monetary asset. This also requires the lender(s) to participate in risk-sharing.
Other key principles guiding Islamic finance include:
i. financing must be linked to real assets;
ii. involvement in immoral or ethically problematic enterprises not permitted (for example, arms production or alcohol production); and
iii. Returns must be linked to risks.
Non-Interest Banking in Nigeria
Since non-interest banking is based on several restrictions that do not exist in conventional banking, special financing arrangements have been developed to comply with the principles of Sharia. The prevalent types of Islamic financing/transaction practiced in Nigeria include the following:
Mudarabah is a partnership arrangement for profit-and-loss sharing. Under this type of agreement, the owner of the capital (rab-ul mal) releases capital to an expert manager (mudarib) who is responsible for managing and investing the capital.
In this agreement, the profit-sharing ratio is agreed upon by all parties before the contract is signed and allocated at the end of the project between the capital owner and the expert manager. In the event of a loss, the owner of the capital shall bear all financial losses and the principal shall be reduced by the amount of the loss. The only loss that the expert manager will incur is their time and work.
The Islamic finance world’s equivalent of a joint venture is Musharakah. Both parties contribute capital and share profit and loss on a pro-rata basis (that is based on how much capital they put up).
Musharakah is only considered a profit-and-loss sharing partnership if more than two parties provide the capital to finance a project – often an investment in real estate or movable assets – either on a permanent or diminishing return basis.