On Islamic Banking

Bank of Zambia Governor, Dr. Michael Gondwe, launched a framework for Islamic banking in Zambia. Just what is Islamic banking?

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. Shari'ah is the legal framework within which the public and some private aspects of life are regulated for those living in a legal system based on Islam.

The principles which emphasise moral and ethical values in all dealings have wide universal appeal. Shari'ah prohibits the payment or acceptance of interest charges (riba) 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. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims.

Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari'ah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking activities must be practiced consistent with the Shari'ah and its practical application through the development of Islamic economics. Many of these principles upon which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades. These principles are not new but arguably, their original state has been altered over the centuries.

It is evident that Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

The revival of Islamic banking coincided with the worldwide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalisation of the oil prices, which had hitherto been under the control of foreign oil corporations. These events led Muslims to strive to model their lives in accordance with the ethics and principles of Islam.

Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations.

Islamic banking is unique in the way that it helps individuals as well as businesses build tangible and appreciating assets for themselves. This not only leads to prosperity founded on a solid economic base, but also encourages the spirit of entrepreneurship amongst its customers. Islamic banks are based on the unique concept of profit and loss sharing with the customers by way of various Sharia-compliant financing and investment tools.

Islamic banks provide an opportunity to the individuals and the businesses to build various assets which contribute to the development of the economy. Apart from this, the Islamic banks encourage the investment process through adopting innovative Sharia structures in all spheres of the economy, except in a few activities which are considered unethical. Islamic banking is perhaps the only financial system to forbid the use of its finances or services for misleading, dishonourable, immoral and other purposes that would be harmful to society. These include all forms of gambling, and firms dealing in pork or alcohol.

Due to their very nature of complying with the Sharia principles, the Islamic banks are forbidden from indulging in any such practice, which may prove harmful to a customer.

Islamic banking therefore offers a portfolio of innovative, Sharia-compliant financial models that formalize this unique arrangement between customers and the bank. These are Murabaha, Musharaka, Mudaraba, to name a few.

Murabaha is a simple form of sale and buy-back agreement. Here, the bank buys the house, car or other commodity and sells it to the buyer at a profit but allows them to pay in instalments. In this case, the profit margin should be clear, agreed upfront and reflect the bank's costs in providing the service.

Similarly, Musharakah describes a joint venture between a bank and business where the profits are divided according to their relative capital inputs. In this way, bank returns are tied to company profits and the partnership ends when the loan is repaid. This approach could be used to provide mortgage financing to buy a property. The property earns rent from the occupier which is paid to the buyer and the bank in relation to their share of the equity.

At the same time, the buyer agrees to buy the bank's share in instalment payments, so over time their equity increases and the bank's falls, until the mortgage principal is paid off.

Mudaraba is a profit sharing arrangement like a venture capital deal where the bank provides the finance and the borrower the labour and entrepreneurship. If the business were to fail, the lender loses their money and the borrower the time and effort committed to the enterprise.

Islamic banking has some challenges. Islamic banks tend to be much smaller than their conventional counterparts, making it hard to achieve economies of scale. There is also far less standardisation in the products available because of different interpretations between banks and jurisdictions of what is acceptable under shari'ah law. Islamic banking products are also more complex which adds to their cost.

The importance of face-to-face relationships means the branch network is important, but has resulted in an underdevelopment of phone and internet banking. It remains to be seen how Islamic banking will operate in Zambia.