It is a common myth that Islamic Finance is only for Muslims. This is far from the truth as Islamic banking is open to people of all religions. It actually benefits the customer more than conventional banking. For instance, under the CBK Act of Kenya, banks can’t legally charge anyone an interest rate above 4 percent of the Central Bank Rate (the lowest rate which the central bank charges on its loans to commercial banks). This was a move hailed by many as salvation from the greedy banks that charged high-interest rates.
However, in the aftermath of the capping, the taps pouring loans to small and medium sized enterprises (SME) are drying. Why is this so? SMEs are seen as too risky and with the decreased interest earnings from loans, banks are instead loaning to bigger more secure players rather than smaller riskier businesses. All is not lost though, there is still a player in the financial services market not affected by the interest rates drama and that player is Islamic Finance.
What is Islamic Finance?
Islamic finance is simply the provision of financial services in accordance with Sharia/Islamic law, principles and rules. Sharia law demands that parties involved must share the risks and rewards of a business transaction. Transactions must be free from speculation and without exploiting anyone.
Henry Kosgei, Kenya’s finance minister, while outlining the country’s 2017/2018 budget said that the government would amend the public finance management act to provide for the Issuance of Sukuk. To many, Sukuk must have sounded like a word from the western part of Kenya but it is simply a concept in Islamic finance. Sukuk is a concept where for example the government wants to raise money to construct a port. So, it gives investors an opportunity to buy a Sukuk which represents a share in an existing or yet to come asset (in this case, the port). This is equivalent to a bond in conventional banking.
However, Islamic banking doesn’t allow interest (riba) but Investors are rewarded with a share of the profit or share in the loss of the asset, within an agreed time. Once the Sukuk (Islamic bond) matures the investor gets back their invested money as per the current value of the asset. In other words, if one invests in Sukuk worth sh1 million: at the time of the Sukuks’ maturity, the value of the port the government invested in has doubled. Then the value of your Ksh. 1million Sukuk investment is also doubled.
Sukuk vs conventional Bonds
While Sukuk investment involves actual buying and owning a share in an asset. Conventional bonds differ in that when one buys a government bond, for instance, it’s like loaning the government without actually owning any asset. You will be receiving fixed interest payments on your investment until a maturity when you get back your full investment.
Personal Loans (Murabaha)
The equivalent of personal loans in Islamic Finance is called Murabaha. For example, a customer asking for a car loan under murabaha will have to enter into a contract with a bank. Since Islamic banks don’t charge interest, the bank will buy a car and resell it to the customer at a higher price than the original. The customer pays the bank in instalments within an agreed period. The money the bank gains from the transaction is referred to as ‘profit rate’ instead of interest rate.
Even though this model of banking might seem unconventional and strange to some of us, it has proven successful. According to the International Monetary Fund (IMF) website, over the last decade (2003-2010) Islamic Finance assets grew in double digits, outperforming conventional banking.
Advantages of Islamic Finance
- Islamic banking offers a higher return on investment, through profit based investment accounts, profits from investments made by the bank on behalf of clients are equally shared depending on each party’s contribution. Conventional banks, on the other hand, can sometimes only offer clients a fraction of the amounts in their accounts depending on how low/high their interest rates are.
- Investments are more secure in Islamic finance because they are approached cautiously, with more scrutiny in order to find out if they comply with sharia principles. This careful auditing process though meant to ensure compliance with Islamic principles enhances the quality of investments conducted by Islamic banks.
- Guarantee of ethics and morals, since they are at the centre of Islamic finance and not just part of a company’s paperwork. A customer doesn’t have to worry about banks engaging in unscrupulous investments or defrauding them,
- In Islamic insurance (Takaful), when one fails or is unwilling to pay the agreed premium, the insurance is mandated to return the premium as opposed to conventional banking where premiums are forfeited on failure to continue paying.
- Still in Takaful, because the money you give as a premium is invested, sharia principles demands them to share the profits earned with all contributors. Under conventional, insurance when was the last time any of us received a significant share the insurer’s profit?
- In Takaful even if a risk doesn’t occur, after the premium maturity date the insured partly gets back their premium contribution. Where else, in conventional insurance if a risk doesn’t occur before maturity date you get nothing in return.
Other products in Islamic Finance include Mudarabah (partner system), Musharakah (profit sharing banking) among others. Islamic Finance adds variety to our banking sector, let us muster the courage and explore Islamic Finance.
Featured image via https://iib.umt.edu.pk