I am highly delighted to be in your midst this morning to share with you a little of the concept of Islamic Finance. I am particularly delighted by your choice of the topic because it points to how much you are following developments in the nation’s financial services industry. Few years back, you would have hardly contemplated this topic because the incentive for it was not there. Today, the situation is different with the restructuring going on in the banking sector and the coming on board of the non-interest banking system under which Islamic banking can be operated by those desirous of doing so. Your foresight is therefore commendable as it will facilitate the sensitization of your constituency towards understanding the concept and operation of Islamic banking which will now be another option available for Nigerians in their quest to achieve economic development.
2. What is Islamic Finance?
Islamic finance refers to the financial system in which services, instruments and transactions are done in accordance with shari’a principles. The tendency is for people to see Islamic finance as simply being Islamic banking and the avoidance of interest. It goes beyond that. Indeed Islamic banking is only an aspect of Islamic finance. The bigger picture of Islamic finance includes such other areas as Islamic insurance, Islamic capital market, Islamic asset management. It also includes or involves other important principles, which encourage entrepreneurship, risk-taking, transparency, preservation of property rights and ethical values such as justice, fair dealing and fair pricing, mutual cooperation and respect of the other contracting parties. Thus, I want to assume that the focus of the organizers is perhaps not on Islamic finance in its entirety but on Islamic banking because that is one of the most current issues in Nigeria today. I seek your indulgence therefore to focus this paper on that. Another observation I would want to make in this regard is that Islamic finance or Islamic banking as the case may be and as conceptualized and operated in the modern time have not started operating fully in Nigeria yet. There is therefore not much to talk about it now. The paper will therefore highlight basic operational issues of Islamic banking as practiced in other jurisdictions that have started it and as will be expected to be practiced in Nigeria subject to whatever modifications that might be effected. It will also provide a short overview of the regulatory framework that will facilitate its operation. Also to be highlighted will be the prospects the banking system will have in the country as well as possible challenges it may face.
3. Islamic Banking
A bank is a financial institution that serves as a financial intermediary between the surplus and deficit units of the society. A commercial bank accepts deposits from individuals, groups or organisations, pools them together and, as may be required, convert them into credit, either directly by lending, or indirectly by investing through the capital markets. Because of the important role banks play in the financial system and in the economic development of nations, the banking industry is highly regulated, and government restrictions on financial activities by banks have varied over time and by jurisdictions. The modern banking which has its root from the west has dominated the banking business globally and is founded on the principle of “interest”. Islamic banking on the other hand is an emerging variant of the conventional banking and its intermediary role in the system is based on the cardinal principle of” interest avoidance”.
4. Foundation of Islamic System of Banking
The essential feature of Islamic banking is that it is interest-free. Islam prohibits Muslims from taking or giving interest (riba) regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. Riba is a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specified time period.
The prohibition of riba is mentioned in four different revelations in the Qur’an.1 The first revelation emphasizes that interest deprives wealth of God’s blessings (Al-Rum: 30: 39). The second revelation condemns it, likening it with wrongful appropriation of property belonging to others. The third revelation enjoins Muslims to stay clear of interest for the sake of their own welfare. The fourth revelation establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and to forgo even this sum if the borrower is unable to repay. It is further declared in the Qur’an that those who disregard the prohibition of interest are at war with God and His Prophet. The following are some of the verses that condemned riba (interest)
“But Allah has permitted Trade and forbidden riba” (Al-Baqarah:275)
“O you who believe! Fear Allah and give up what remains of your demand for riba, if you indeed are believers. If you do it not, take notice of a war from Allah and His Messenger; but if you turn back, you shall have your capital sums; deal not unjustly and you shall not be dealt with unjustly “ (Al-Baqarah:278-279).
The prohibition of interest is also clearly stated in several of the ahaadeeth (sayings of the prophet). The prophet condemned not only those who take interest but also those who give interest and those who record or witness the transaction, saying that they are all alike in guilt. An example of the ahaadeeth that prohibited interest (Riba) is
“Avoid the seven grievous sins” They asked: “What are they. O Messenger of Allah?” He (p.b.u.h.) replied, “Associating anything with Allah, magic, killing a soul which Allah has declared inviolate without a just cause, devouring the property of an orphan, dealing with riba (interest), fleeing on the day of fighting, and culminating the chaste, innocent, believing woman.” (Muslim)
Although the initiative for non-interest banking was spearheaded by mainly men of Islamic faith in apparent desire to comply with the dictates of Shari’a, the major principle underlying the operation of Islamic banking, which is avoidance of interest, is by no means peculiar to the Islamic faith. Indeed earlier scriptures before the Holy Qur’an made similar prohibitions as can be seen from the following verses:
“Thou shall not lend upon usury (interest) to thy brother, usury (interest) of money, usury of victuals, usury of anything that is lent upon usury.” (Deuteronomy 23:19)
“Then I consulted with myself, and I rebuked the nobles, and the rulers, and said unto them, Ye exact usury (interest), every one of his brothers. And I set a great assembly against them.” (Ezekiel 22:12)
5. Background to the emergence of Islamic Banking
The first modern efforts at implementing Islamic banking system was undertaken in Egypt under cover in 1963, without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. It was not a standard bank and it operated on the basis of profit sharing arrangement. By 1967 there were about nine of such institutions (Ready 1981), by which time there were nine such banks in the country. These institutions neither charged nor paid interest but invested in trading and industry directly or in partnership with others, and shared the profits with their depositors (Siddiqi 1988). The Nasir Social Bank, established in Egypt in 1971, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law).
The IDB was established in 1974 by the Organization of Islamic Countries (OIC), but it was primarily an inter-governmental bank aimed at providing funds for development projects in member countries. The IDB provides fee-based financial services and profit-sharing financial assistance to member countries. The IDB operations are free of interest and are explicitly based on Shari’a principles.
6. Contemporary Developments
The surge for the establishment of Islamic banks started in the seventies when changes took place in the political climate of many Muslim countries so that there was no longer any strong need to establish Islamic financial institutions under cover. A number of Islamic banks came into existence in the Middle East, e.g., the Dubai Islamic Bank (1975), the Faisal Islamic Bank of Sudan (1977), the Faisal Bank of Egypt (1977), and the Bahrain Islamic Bank (1979), to mention a few. The Asia-Pacific region was not oblivious to the winds of change. The Phillipine Amanah Bank (PAB) was established in1973 by Presidential Decree as a specialized banking institution without reference to its Islamic character in the bank’s charter. The establishment of the PAB was a response by the Phillippines Government to the Muslim rebellion in the south, designed to serve the special banking needs of the Muslim community. However, the PAB operated two ‘windows’ for deposit transactions, i.e., conventional and Islamic. Islamic banking made its debut in Malaysia in1983 with the establishment of Bank Islam Malaysia Berhad (BIMB) which represented a full-fledged Islamic commercial bank in Malaysia.
Reference should also be made to some Islamic financial institutions established in countries where Muslims are a minority. Some of these include Switzerland, Thailand, Singapore, Canada, United States, Australia and the UK. Indeed, from a study carried out by the Islamic Deposit Insurance Group, we learnt that from about 100 financial institutions in 1997, the Islamic financial institutions have grown to more than 300 institutions in over 75 countries with asset projected to grow to USD 1.6tr globally by 2012.
7. Basic Operational Issues in Islamic Banking
7.1.1 Riba (Interest)
Riba is a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specified time period. Under Islamic system, any return on money must accompanied by risk, which is absent in interest system.
7.1.2 Gharar (Uncertainty)
This refers to uncertainty due to information gap in a contract situation. It also includes cases where the subject of the contract is something over which neither party has control. Therefore, contracts must be drafted as clearly as possible to avoid any gharar in the quantity, quality, or existence of the subject matter of a contract.
7.1.3 Maisir (Gambling)
This is the betting of money or something of material value on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods. It is an unproductive exchange of property where one side wins and the other side loses.
7.1.4 Sale or purchase of unlawful goods and services such as pork, alcohol, pornography, etc.
7.2. Ethical Requirements
Muslims have a moral obligation to conduct their business activities, as well as their personal life, in accordance with the requirements of their religion. Those requirements include moral values and business ethics.
Indeed, they should be fair, honest, humble and just towards others. It is a duty for them to earn a living, support their families, and give charity to those less fortunate. In their business activities, it is a moral obligation to fulfil their promises and commitments, pay their liabilities.
The Qur’an is very explicit on moral values. The following are some of the verses that hammer on moral issues :
“Malice against a people should not prompt you to avoid doing justice. Do justice. That is nearer to Taqwā (God consciousness)”.
“And fulfil the covenant. Surely, the covenant shall be asked about (on the Day of Reckoning)”.
7.3. Types of Deposits/ Accounts that could be operated
7.3.1 Current Account:
All Islamic banks operate current accounts on behalf of their clients: individual and business firms. These accounts are operated for the safe custody of deposits and for the convenience of customers. There is little difference between conventional banks and Islamic banks as far as the operation of current accounts is concerned. However the main characteristics of these accounts as operated by Islamic banks are listed below:
i) Current accounts govern what is commonly known as call deposits or demand deposits (Al-Wadi’ah). These accounts can be opened either by individuals or companies, in domestic currency or in foreign currency if the bank is allowed to operate in the foreign exchange market and the holding of current balances in foreign currency is legal under the law of the land
ii) The bank guarantees the full return of these deposits on demand and the depositor is not paid any share of the profit or any other return in any form.
iii) Depositors authorise the bank to utilize their funds at the banks own risk. Hence, if there is any profit resulting from the employment of these funds, it accrues to the bank and if there is any loss, it is also borne by the bank.
iv) With these accounts, there are no conditions with regard to deposits and withdrawals.
7.3.2 Savings Account
Islamic banks also operate savings account. However, the modality varies from one jurisdiction to another. One of the modalities is where the bank accepts deposits on the principle of Al Qard al- Hassan requesting depositors to give permission to the bank to use these funds at its own risk, but guaranteeing full return of deposits and sharing any profits voluntarily.
7.3.3 Investment Deposits
i. Investment deposits are Islamic banks’ counterparts of term deposits or time deposits in the conventional system. They are also called Profit and Loss Sharing (PLS) Accounts or Participatory Accounts.
ii. While fixed term deposits in the conventional system operate on the basis of interest, investment accounts in Islamic banks operate on the basis of profit sharing. Instead of promising depositors a predetermined fixed rate of return on their investment, the bank tells them only the ratio in which it will share the profits with them. How much profit each depositor earns depends on the final outcome of the bank’s own investment.
iii. Investment accounts are usually opened for a specific period, e.g. three months, six months, one year or more.
7.4. Types of Products
The major investment conventional banks engage in is interest-based lending. Although the banks do evaluate the object for which lending is needed, the major concern is often on the creditworthiness of the borrower and his ability to pay back the loan through the use of appropriate collateral. On the other hand, since Islamic banks do not operate on the basis of interest they adopt asset-backed financing as the basis of their investments. Under this mode of financing a number of options are available to the banks that are within the fold of shari’a requirement. These include:
7.4.1. Musharakah: This is where a bank may decide to join another entity to execute a project or set up a joint venture with each contributing particular amount in equal or varying degrees. While Profit can be shared according to a pre-arranged formula, losses are shared in proportion to capital contribution.
7.4.2 Mudarabah: The bank contributes the finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank.
7.4.3 Murabaha: In a Murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before reselling it to the client on a “cost-plus” basis. The payment can be on the spot or deferred or instalment.
7.4.4 Istisna’ : This is another mode of financing Islamic banks engage in. the client may seek finance for the construction a house. The financer or the bank may decide to construct the house to specification and payment is decided in whatever manner agreed by the parties.
7.4.5 Salam: Salam is another form of financing in which the seller undertakes to supply some specific goods to the buyer at a later date that is agreed in exchange of an advanced price fully paid on the spot.
7.4.6 Ijarah: An Ijarah contract is where the financier buys and leases equipment or other assets to the business owner for a fee or a rental income. The duration of the lease as well as the fee must be set in advance and mutually agreed. To be acceptable as an Islamic financial product, the leasing contract must, among other things, ensure that the service that the asset is supposed to provide and for which it is being rented should be definitely and clearly known to both parties.
8. Agitation For Islamic Banking
The agitation for Islamic (interest-free) banking in Nigeria has taken quite a while. However, its manifestations started crowding from 1991 when government started taking responsive actions towards actualizing it. The Banks and Other Financial Institutions Act (Amended) of that year recognized banks that are established on the basis profit and loss sharing. Other manifestations include:
In 1996 Habib Bank Plc opened a non-interest banking window but could not register significant success because of absence of framework for non-interest banking.
In 2003, during Obasanjo’s tenure Nigeria became full member of the Islamic development Bank.
In 2004, approval in principle was granted to Jaiz Bank to operate full fledged Islamic bank subject to meeting mandatory capital requirement of N25 billion.
In Jan. 2009 the Central Bank under Prof. Charles Soludo joined the International Financial Services Board as full member. The IFSB is an international standard-setting organization for the Islamic financial services industry.
In March 2009 the Banking Supervision Department of the CBN released the exposure draft of the framework for the Regulation and Supervision of Non-Interest Banks in Nigeria for comments by Stakeholders.
In Jan. 2010, the CBN Governor, Sanusi Lamido Sanusi, set up a non-interest banking unit in the CBN.
In Aug. 2010, the CBN released the new banking model, which included non-interest banks among the specialized banks and will operate either at National or Regional level with capital requirements of N10 billion and N6 billion respectively.
In Sep. 2010, the Nigeria Deposit Insurance Corporation (NDIC) released its exposure draft on Non-Interest (Islamic) Deposit Insurance Scheme for comments by stakeholders.
SEC has issued rules on Islamic Fund Management
Debt Management Office getting set for development of Sukuk (Islamic Bond)
9. Potential Benefits of Islamic Banking
9.1 Financial Inclusion: It will facilitate financial inclusion so that nobody is prevented in the country from participating in the financial services business and so that the economy will get a bigger boost.
9.2. Diversification: The entry of new products into the financial system will stimulate diversification and give investors several investment options.
9.3 Enhanced Competition: There will be enhanced competition due to the entry of new market which will enhance efficient service delivery.
9.4 Development of the Real Sector: Because of its emphasis on asset-based lending, Islamic banking will contribute the development of the real sector of the economy.
10. Regulatory Imperative
Because of the nature of banking business and its link to a nation’s economy and payment system, it is highly regulated worldwide. The Islamic banks in Nigeria, just as the conventional banks, will come under supervision and regulation of the Central Bank of Nigeria. Indeed, the CBN has already issued the regulatory framework for the operation of the banks in Nigeria. The framework covers such critical banking issues as licensing requirements, instruments of transacting business, establishment of non-interest window by a conventional bank, prudential guidelines, risk management and auditing, accounting and other disclosure requirements.
11.0. Corporate Governance
The corporate governance provisions approved by the CBN to moderate the management of non-interest banks in Nigeria include:
11.1. All licensed NIFIs shall be subject to:
Guidelines on corporate governance for non-interest financial institutions issued by the CBN;
The provisions of the Code of Corporate Governance for Banks in Nigeria issued by the CBN and any subsequent amendments thereto; and
All relevant provisions of BOFIA 1991 (as amended) and CAMA 1990 (amended).
11.2. All licensed NIFI (Islamic banks) shall have an internal compliance review mechanism and an Advisory Committee of Experts as part of their governance structure. The detailed guideline for the appointment, operation, qualification, duties and responsibilities of the advisory committee of experts are also provided by the CBN.
11.3. The Central Bank itself shall an advisory body on non-interest banking and financial services which shall advise it on related matters.
12.0. Provision of Deposit Insurance Cover
The supervisory role of the CBN will be complemented by the supervision of the Nigeria Deposit Insurance Corporation (NDIC), which will give deposit insurance cover to the banks when they become fully operational. Already work has reached advanced stage to release a framework for non-interest (Islamic) deposit insurance scheme. The need for deposit insurance cover stems from the public policy objectives to:
Protect depositors against loss in the event of failure of any of the non-interest (Islamic) banks.
Engender public confidence and enhance the resilience of non-interest (Islamic) financial institutions.
Encourage competitiveness of non-interest (Islamic) financial institutions.
Help provide an orderly failure resolution mechanism.
The membership of the scheme is likely to be mandatory in line with best practice and will attract contributions from member institutions. The maximum deposit Insurance Coverage is also likely to be the same as that of deposit money banks. The model the NDIC is proposing is one that seeks to establish separate deposit insurance funds for the conventional and the non-interest (Islamic) banks and each fund will be managed in accordance with its stipulated guidelines.
13.0 Prospect For Islamic Banking in Nigeria
Against the background of what has been achieved so far especially with regards to regulatory requirements, it may not be out of place to say that with other things appropriately addressed, Islamic banking in Nigeria has prospect for success. Other factors that are likely to increase the prospect include:
13.1 Awareness Campaign that is on going by the CBN, NDIC, Media publications and other efforts by other civil organizations such as the one we are witnessing now.
13.2 Provision of deposit insurance cover by the NDIC
13.3 Possible patronage by the teaming Muslim population that had hither-to abstain from banking due to interest elements in the conventional banking.
13.4 Acceptance as potential alternative to the conventional banks
13.5 Possible patronage by ethical Christians.
13.6 Global acceptance of the system.
It is worth noting that so far Ja’iz International has been granted provisional license for full fledged Islamic banking while Stanbic IBTC has been granted provisional license to operate an Islamic banking window.
14.1 Public Awareness
14.2 Knowledge and Skill for both operators and regulators
14.3 Shari’a scholars knowledgeable in conventional banking
14.4 Governance challenge
14.5 Development of appropriate instrument to facilitate liquidity management
Finally, it should be noted that some of the issue addressed are by no means exhaustive. However, I believe it would serve to give an insight into the concept and operations of Islamic banking while I also hope that there could be some more contributions from members of both the high table and the floor on critical areas overlooked. However, it suffices to note that Islamic banking is a system that needs not generate fear and temper. It is a system that will bring about risk diversification. It is a system that will facilitate financial inclusion and healthy competition, which are needed for the country’s overall development especially in its quest to achieve the 20:20:20 objective. It is hoped that with the backing of the government and the regulators and the market discipline that is expected from both the operators and the banking public the system will succeed for the overall good of Nigeria and Nigerians.
Thank you all for listening.