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:
- financing must be linked to real assets;
- involvement in immoral or ethically problematic enterprises not permitted (for example, arms production or alcohol production); and
- 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:
1. Profit-and-Loss Sharing Partnership (Mudarabah)
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.
2. Profit-and-Loss Sharing Joint Venture (Musharakah)
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.
This is where it gets interesting, musharakah comes with the most risk out of all the Islamic banking modes, as well as the potential for gaining the highest reward. It is worthy to note that all musharakah partners can participate in the project management process.
3. Leasing (Ijarah)
Ijarah is a contract for the sale of the right to use the asset for a specified timeframe. Similar to the transaction between a landlord and a tenant, the lessor transfers property ownership to the lessee for the duration of the contract in exchange for a stream of rent as the purchase payment.
Although ownership remains with the lessee for the duration of the contract, the asset may be reclaimed by the lessor in the event of non-payment. However, unless harm to the leased asset arises from the negligence of the lessee, the lessor is also liable for asset repair.
Regulations Governing Non-Interest Banking in Nigeria
The Central Bank of Nigeria (CBN) regulates banks and financial institutions, including Islamic banks. CBN derives its power to regulate the Islamic banking system in Nigeria from the provisions of the CBN Act, 2007 and other relevant laws such as:
- Banks and Other Financial Institution Act (BOFIA), Cap B3 Laws of the Federation of Nigeria (LFN) 2004; and
- The Companies and Allied Matters Act (CAMA) Cap C20 LFN 2004.
CBN also issues policies, rules, circulars, guidelines and regulations in line with the extant laws to regulate non-interest banking in Nigeria. Some of the guidelines are as follows:
1. Guideline Covering Non-interest Financial Services Provider Institutions in Nigeria.
This Guideline was issued in pursuant to the non-Interest banking rule per Section 33 (1)(b) of the CBN Act 2007; Sections 23(1) 52; 55(2); 59(1) (a); 61 of Banks and Other Financial Institutions Act (BOFIA) and Section 4(1) (c) of the Regulation on the Scope of Banking Activities and Ancillary Matters, No. 3, 2010.
This Guideline is focused on non-interest financial institutions operating under the principles of Islamic Commercial Jurisprudence, one of the categories of non-interest financial institutions (NIFIs).
2. Non-Interest (Islamic) Microfinance Banks Regulation Guidelines in Nigeria.
In April 2017, CBN issued a Guideline on the Regulation and Supervision of Non-Interest Microfinance Banks in Nigeria. This guidance is intended to provide the traditional microfinance and the non-interest microfinance banks with a level playing field. To offer to the public an alternative system to the presently available conventional microfinance banking system - a microfinance bank that operates based on the concept of profit and loss sharing rather than the charging of interest.
Financial Reporting and Accounting for Islamic Transactions
As the practice of Islamic finance gains wider acceptance, the key challenge along its path is the availability of a relevant and accurate accounting framework that is both traditional banking-friendly and Sharia-compliant. That is where the International Financial Reporting Standards (IFRS) comes in. Although some experts think IFRS and Islamic finance are not compatible, it is widely believed that IFRS can be applied appropriately to most Sharia-compliant finance products and transactions.
As a matter of fact, IFRS and related local standards have been successfully applied to Islamic finance in certain territories (Malaysia, United Arab Emirates and the United Kingdom). Since IFRS focuses on the economic substance of a product or transaction rather than its legal form, IFRS principles rather than the Islamic legal form will ultimately determine accounting treatment.
The transparency and global comparability of financial reporting for Islamic finance would be strengthened if guidelines and principles established by organizations such as the Islamic Financial Services Board (IFSB) and the Islamic Financial Institutions Auditing Organization (AAOIFI) are harmonized with IFRS requirements.
The IFSB is the global body responsible for issuing global guidelines and guiding principles for the Islamic finance sector, including insurance, banking, and capital markets. Furthermore, the IFSB funds research and coordinates initiatives on industry-related issues. The AAOIFI also sets Sharia guidelines for Islamic institutions, as well as guidelines for governance, ethics and auditing. In its bid to regulate the governance structures and human resource base of the Islamic finance industry, AAOIFI offers professional qualifications programs (notably CSAA and CIPA).
Risk Management for Non-Interest Banking
Currently, non-interest banking is growing and developing rapidly. As the pace of the growth becomes faster, the risks and challenges will become more complex. Hence, non-interest banks need to anticipate changes in the financial world.
The risk management practices in Islamic finance must not violate Sharia laws. For instance, most derivative contracts are forbidden and considered invalid because of the uncertainty involved in the future delivery of the underlying asset. Derivative contracts are commonly used in conventional banks as hedging instrument. As a result risk management in Islamic banking becomes more dynamic.
The top risks for Islamic banking are financing risk (credit risk), market risk, operational risk, liquidity risk, legal risk, Sharia compliance risk, equity investment risks, displaced commercial risks, rate of return risks, strategic risk, investment risk, among others.
In managing these risks, the Islamic banks should develop risk management framework and methods to mitigate these risks. This will involve the banks developing their risk management objective and strategy, as well as identifying, measuring, and mitigating risks; running supervision; and reporting the implementation of risk management in line with the requirements of Basel II. Risk reporting should cover the Internal Capital Adequacy Assessment process (ICAAP) which embeds the Capital Adequacy Ratio (CAR) and Pillar 2 risk.
These reports would become more important with the implementation and adoption of Basel III by the CBN. Risk reporting provides information on the bank's operational details (especially with regards to its solvency and liquidity position) and the level of risk inherent in each of its current business activities.
Risk management practices need to be conducted continuously, the same way that risks constantly change and grow in amount and variety.
With over 100 million Muslims, Nigeria is home to the largest population of Muslims in sub-Saharan Africa.
The implementation of the Non-Interest banking in Nigeria is poised to promote healthy competition in the financial market. This could lead to a reduction in interest rates, which would help to drive the Nigerian economy and ensure its steady growth.
We should therefore conclude that, in Nigeria, the future of Islamic finance holds a great deal of promise. However, as more businesses in Nigeria adopt Islamic financial practices, one can only hope that the CBN will issue consistent policies, rules and guidelines on risk management and transparent financial reporting for non-interest banking and finance in Nigeria.
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