Sources of income for non-interest (Islamic) banks
Whatever income NIFIs earn through Shariah non-compliant activities/transactions are given away to charity.
Non-Interest Financial Institutions (NIFIs) or Islamic Financial Institutions (IFIs), are banks and other financial institutions that provide financial products and services based on Islamic commercial jurisprudence or any other non-interest principles. Such formal institutions are fully regulated by the relevant authorities in Nigeria, as provided for in sections 9, 23 and 52 of the Banks and Other Financial Institution Act (BOFIA) 1991, as amended.
Indeed, the non-interest financial system is not limited to banking; it also covers insurance, capital markets and other financial intermediation underpinned by, Shariah, moral or ethical principles. As a divine law, Shariah prohibits certain types of income, including interest income (riba). The Islamic law also prohibits gambling and other dubious transactions.
Globally, the major financial products offered by NIFIs are banking products. Islamic banking products account for the largest share of Islamic finance assets.
The main question that this article aims to provide an answer to is: What are the permissible categories of income for NIFIs, since they do not pay or receive interest? One of the best ways to understand this business model is to gain an understanding of the products and services considered as acceptable under Shariah.
The important thing to note is that all the financial products of NIFIs are interest-free and guided by the Shariah principles advocating risk sharing. Any return generated by any NIFI without sharing in the underlying risk is considered interest and, thus, prohibited under Islamic finance. Whatever income NIFIs earn through Shariah non-compliant activities/transactions are given away to charity.
Conventional financial institutions depend on interest charges from lending as a major source of their income and earnings. Since non-interest banks (NIBs) cannot charge interest on lending as a means to generate their income, they look for innovative ways of generating income that does not involve interest charges.
For these NIBs, income is generated through the provision of fee-based services like wakala, or through profit-on-sale techniques like Murabaha, Salam, Istisna, etc. (all explained later in the next segments of this article). Income can also be generated by the NIBs through the provision of usufruct to clients via leasing arrangements, such as normal lease and lease-to-own. NIBs can also enter into various forms of joint enterprise or partnerships with clients whereby both the risks, profits and losses are shared between the NIBs and the clients, based on pre-agreed conditions. Examples of such partnerships include Musharakah, Mudarabah, Muzara’a, etc.
The following are Shariah-compliant frameworks that underpin the sources of income for NIBs:
Like conventional banks, NIBs provide fee-based services, also called Ujrah-based services. Using a wakala agreement, the NIB can issue a Letter of Credit (LC) and some other trade related documentations to its clients. So doing, the bank acts as an agent or wakil for its client. The bank then charges a fee or commission for the service provided. Other fee-based services include Automated Teller Machine (ATM)-based services, internet banking, mobile banking, bank drafts, statement of accounts, etc. Although these services are also offered by conventional banks, they are not interest-based.
Islamic law does not allow for financial products where gharar exists. Gharar refers to uncertainty or where conditions of the sale are unknown or uncertain. To ensure certainty in the transaction, profit-on-sale is one of the frameworks used in Islamic finance. One of the tools underpinned by profit-on-sale is called Murabaha. It is a popular sale contract in which the bank agrees to sell commodity purchased from a third party (vendor) to the client with a mark-up. Then the client buys the commodity either against immediate payment or deferred payment.
Another contract of sale is salam. This is a forward purchase of specified goods for full future payment. The NIBs use this contract to generate income by financing agricultural production. In the case of Istisna, which is also a sale contract, the NIBs use this type of contract to finance construction and manufacturing projects. Under Istisna, one party buys the goods and the other party engages in the process of manufacturing them, according to agreed specifications with payments made either on the spot or in installments. In all the above-mentioned contracts, the bank sells an item/asset to the customer at a price that includes its cost and profit.
NIBs find a lot of opportunities in leasing because of its benefits and the asset-based nature of investment in Islamic finance. Under lease or Ijarah contracts, the lessee (the bank's customer) enjoys the benefit of using the asset by making regular rental payments to the lessor (the bank) for an agreed-upon price and for a period of time. At the end of the lease, the asset is repossessed by the bank. This form of normal lease (or operational lease) is permissible under Shariah provided other conditions are met.
Lease-to-own (Ijarah wa Iqtina) is a form of asset finance where the lessee’s periodical payments include rent and gradual payment of the cost of the asset. Upon making full payment for the asset at any point during the period of the lease, the bank will transfer the title of the asset to the client.
Islamic partnership contracts are best represented by equity-based principles. For instance, Mudarabah and Musharakah are simply Shariah-compliant tools for pooling capital that generates income for the NIBs and transacting other businesses. Indeed, both concepts provide an opportunity for the partners to share profits and risks in the business, instead of one party being a creditor and the other a debtor.
In Mudarabah, the profit realized from the venture is shared among the partners based on an agreed-upon ratio. Mudarib, who is an entrepreneur, is paid for the effort invested in running the venture. If there is any loss, the partners who invested in the venture bear the loss, while Mudarib loses the remuneration for the time he invested. Undoubtedly, Mudarabah helps the banks and concerned parties to share the profits realized judiciously.
For Musharakah, both parties contribute capital and entrepreneurial expertise. Under this contract, the sharing of profits is done in an agreed ratio, while the sharing of losses is proportionate to the ownership ratio of the partners.
Muzara’a, also considered as a partnership contract by many scholars, is an agreement between two parties in which one agrees to allow a portion of his land to be used by the other in return for a part of the produce from the land. This contract is adopted by NIBs for financing agriculture projects in order to promote socio-economic development as well as cater for the well-being of the local farmers. In all the aforementioned partnership contracts, the bank’s income is derived from the share of profit from the joint business.
The foregoing are some of the different structured Islamic finance products that can be used to generate permissible incomes for NIFIs, in particular, NIBs. A client needs to understand the basics of Islamic finance before entering into a contract with any Islamic financial institution.
Lukman Muhammad-Rajih is of the Shariah Audit Department of Jaiz Bank Plc.
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