Insights into Islamic banking

Islamic banking is gaining ground and it appears Malawi is not spared either. Some international financial institutions have been making claims that it is a kind of revolution that Malawi needs to increase financial inclusion.

It is a known fact that the cost of finance is high in the country and traditional commercial banks thrive on government borrowing and a few big companies. The emergence of informal banking arrangements such as banki mkhonde whose members are in the predominantly formal jobs is a reminder of difficulties to access capital.

Should we get too excited with Islamic banking? Maybe yes or not but it is important to understand what this banking structure works. What is Islamic banking?

Islamic banking is premised on financial activities that are consistent with the principles of Islamic rulings and its practical application through the development of Islamic economics. The principles are oriented towards moral and ethical values in all dealings and have global appeal. Islamic rulings prohibit the payment or acceptance of interest charges for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles.

In general terms, the core principles of Islamic banking are similar with those of conventional banking. The exception between the two is the fact Islamic banking must operate within the rules of the Shariah. These rules transcend conventional banking legal framework and integrate all aspects of social and religious life with   economics.

One key aspect of Islamic banking is profit and it often raises questions as to whether it can be generated when lending prohibits interest. Profit, according to Islamic theory, is the result of the productivity of capital that an entrepreneur has invested or a reward for his workmanship or for shouldering responsibility.

As capital provider he has to bear the loss, if any, and as entrepreneur he has to pay the wages, rentals and other expenses and gets the residual, if any. All participants in a joint business have similar rights and liabilities according to the nature of the activity or the terms of the agreement. It is for this reason that sometimes Islamic banks have strong hallmarks of mutual funds, the local example being some facilities being traded by Old Mutual Malawi.

So what are the building blocks of Islamic banking?

Equity is a key building block of Islamic finance. The prohibition of interest rates otherwise known as riba in Arabic is built on protecting the weaker parties in a transaction that may lead to huge pay-offs. Such equity is demonstrated in the 2.5 percent levy on cash or in kind wealth (zakat) imposed by Shariah on all Muslims who meet specific minimum levels of income and wealth to assist the less fortunate and foster social solidarity.

At the core of Islamic banking lies the principle of participation that works on the notion of rewarding capital injected into a financial corporation. Ideally, the prohibition of interest does not mean capital should not be rewarded as there is a risk of bank collapse like conventional banking.

While conventional financial intermediation focuses on taking deposits and lending out money, the Islamic financial system promotes the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and-loss-sharing basis. The general rule is that all financial arrangements that the contracting parties agree to use are lawful, as long as they do not include an element of interest. Equity holding and commodity and asset-trading are an integral part of Islamic financing. The two basic categories of financing are profit-and-loss-sharing (PLS), also called participatory modes and purchase and hire of goods or assets and services on a fixed-return basis.

Furthermore, the principle of ownership is quite critical in Islamic finance. It is   based on the notion that no one should sell an item they do not own. Specifically, its mode lies on linking financing to ownership of a typical fixed asset with full property rights. It connects financing to the real economy as opposed to speculative earnings of modern banking or returns that accumulate with the passage of time through compounding.

So, let us get this right. While Islamic banking may appear cheaper, it has some specific rules. You will not borrow money for purposes of investing in a business whose activities are contrary to Islamic teachings. I do not need to explain these, but surely you cannot borrow money from an Islamic bank to build a hotel that will be serving alcohol. Neither can you borrow money to build a casino where people are going to gamble. The good news is that you will be able to invest in a world class hospital or education facility. These are some insights.

Like any other banking business, rules apply. Its money will not flow easily like the taxpayer funded business loans given to under-serving political surrogates. I hope this gets you excited to learn more about Islamic banking. n