ISLAMIC FINANCE: PANACEA FOR THE EMERGING INDUSTRIES IN NIGERIA

Introduction

Islamic Finance rests on the application of Sharia. It is a method of financing and banking operations that abides by Sharia Law. Sharia law is derived from the Quran (believed to be Allah’s divine revelation to the prophet Muhammad) and the teachings of Muhammad.

Muslim believed that Sharia law shows the path to be followed as ordained by Allah.

It covers all aspects of life and Muslim believe that following this path will lead to physical and spiritual wellbeing.

Sharia law sets out five categories of actions that guide a Muslim actions:

These are acts that are:

• Obligatory;
• Meritorious;
• Commendable;
• Reprehensive; and
• Forbidden.

The main principles of Islamic finance are that:

1.  Wealth must be generated from legitimate trade and asset-based investment (the use of money to make money is expressly forbidden).
2. Investment should have a social and an ethical benefit to wider society beyond pure return.
3. Risk should be shared.
4. Harmful activities (haram) such as charging interest (Riba) should be avoided.

The intention is to avoid injustice, asymmetric risk and moral hazard (where the party who cause a problem does not suffer its consequences) and unfair enrichment at the expense of another party.

In addition to the prohibition on charging interest, Islamic financial institutions must ensure that ambiguity (gharar) or gambling/speculation (maysair) is minimised in transactions and contracts. Complying with Sharia law also means that Islamic Financial Institutions are not permitted to invest in alcohol, pork, pornography or gambling. Also, entering into a contracts where there is uncertainty about the subject matter and term of contracts (this include prohibition on short selling, i.e. selling something which is not yet owned) is prohibited.

Islamic finance has grown rapidly, even though it is still a small share of the global financial market. The Islamic banking segment has increased its penetration in many International Monetary Fund (IMF) member countries. It has become systemically important in Asia and the Middle East, while the global issuance of Sukuk - the Islamic equivalent of bonds - is expanding with remarkable international reach of issuers and investors. This trend is expected to continue, driven, in particular, by strong economic growth in countries with large, and relatively unbanked, Muslim populations.

Reflecting the importance of Islamic finance for many of its members, the IMF has had a long-standing interest in its implications for macroeconomic and financial stability, and played a key role in the establishment of the Islamic Financial Services Board (IFSB). The IMF has also engaged its members on the implications of Islamic finance, in the context of its policy advice and capacity development efforts, notably in the areas of regulation and supervision of Islamic banks, and development of domestic Sukuk markets.

This recent growth of Islamic finance has led to increased demand on the IMF. To foster its preparedness, the IMF has formed an Interdepartmental Working Group with the objectives to develop an institutional view on the industry, build in-house expertise and better coordinate with different stakeholders. This working group has stepped up the analytical work on Islamic finance in key areas, including Islamic banking regulation and supervision, macro-prudential policy, safety nets, resolution, financial inclusion, consumer protection, monetary policy, Sukuk markets, public financial management, and tax policy. The IMF established an External Advisory Group, comprised of standard-setters for Islamic finance and leading international experts, to assist in identifying policy issues and to enhance coordination with different stakeholders interested in Islamic Finance.

The overarching principle of Islamic finance is that all forms of interest are forbidden.

The Islamic financial model works on the basis of risk sharing. The customer and the bank share the risk of any investment on agreed terms, and divide any profits between them.

The main categories within Islamic finance are: Ijara, Ijara-wa-iqtina, Mudaraba, Murabaha, Musharaka and Sukuk.

Although, the Cash flows from these techniques might be the same as they would have been under standard western practice. However, the key difference is that the rate of return is based on the asset transaction and not based on interest on money loaned.

* Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period.

* Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract.

* Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits. Customers risks losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns a profit.

* Murabaha is a form of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis.

* Musharaka is an investment partnership in which profit sharing terms are agreed in advance, and losses are pegged to the amount invested.

* Sukuk is a debt finance which does not bear interest. Sukuk holders must have an ownership interest in the assets which are being financed. The sukuk holders’ return for providing finance is a share of income generated by the assets.

Savings and deposit banks that complied with Sharia were launched in the 1960s, says BLME. However, it was not until the mid 1970s that commercial banks began to emerge. The last 20 years has seen the expansion both geographically and across financial services of Islamic Banking. In 2004 the first UK Islamic Bank was authorised by the Financial Services Authority. Conventional banks also identified the potential of Islamic Banking and many have opened Islamic ‘windows’ over the last ten years.

Humphrey Percy, CEO of BLME, says: “Since its establishement in 2007, BLME has witnessed a growing demand among medium to high net worth individuals for a banking option that incorporates the transparent and ethical principles inherent in Islamic finance with competitive returns. With the financial climate improving, individuals are looking to diversify their investments that were previously solely held by UK high street banks.”

Both Muslims and non-Muslims can benefit from Islamic Finance as, by principle, it aims to be a more transparent and fairer system of finance. Many of the instruments or investment methods that have contributed to the financial crisis are not permitted by Sharia, such as short selling or non-asset backed derivatives. 

Islamic Finance Factsheet

According to the International Monetary fund (IMF), Islamic finance currently encompasses banking, leasing, Sukuk (securities) and equity markets, investment funds, insurance ("Takaful") and micro finance, but the banking and Sukuk assets represent about 95% of total Islamic finance assets.

Islamic finance assets grew at double-digit rates during the past decade, from about US$200 billion in 2003 to an estimated US$1.8 trillion at the end of 2013. However, despite its growing spread, Islamic finance assets are still concentrated in the Gulf Cooperation Council (GCC) countries, Iran and Malaysia, and represent less than 1% of global financial assets.

For instance, Islamic banking outperformed conventional banking over the past decade, increasing its penetration rate above 15% in a dozen countries in the Middle East and Asia. Over the same period, Sukuk issuance increased twenty-fold to reach US$120 billion in 2013, and its issuer base is broadening with new issuances in Africa, East Asia and Europe.

For instance, Islamic banking outperformed conventional banking over the past decade, increasing its penetration rate above 15% in a dozen countries in the Middle East and Asia. Over the same period, Sukuk issuance increased twenty-fold to reach US$120 billion in 2013, and its issuer base is broadening with new issuances in Africa, East Asia and Europe.

Islamic Banking

Islamic banking differs from conventional banking in several ways. Unlike conventional banks that operate on the basis of borrowing and lending with pre-specified interest rates, Islamic banks are funded by current accounts that do not attract interest or by profit-sharing investment accounts (PSIA) where the account holder receives a return that is determined ex-post by the profitability of the banks. On the asset side, Islamic banks use a number of contracts such as sales at a profit margin (Murabahah), lease (Ijarah), profit-sharing (Musharakah and Mu?arabah), and fee based services (e.g., Wakalah). All banking business based on sale or lease must have an underlying asset. This is in contrast to conventional banking where the asset's importance lies only in terms of collateral security but the asset is not necessarily part of the loan transaction.

The operations of Islamic banks give rise to a unique set of risks, in addition to the standard risks associated with banking activities such as credit, market, liquidity, operational and legal risks. These unique risks include:

• Shari’ah compliance risk: which arises from the fact that the products offered to customers may, ex-post , not be certified to be compliant with Shari’ah principles;
• Displaced commercial risk: which arises from the fact that while the returns to Profit Sharing Investment Account (PSIA) holders are supposed to depend on the profitability of their investments, PSIA holders would expect similar returns to those offered by conventional banks, and therefore shareholders may have to forego part of their profits;
• Equity investment risk: which emanates from profit-sharing financing instruments that are unique to Islamic banking.

The industry also faces additional risks related to the business model and the nascent nature of the industry. For instance, managing liquidity risk is more difficult for Islamic banks when there are limited or no Shari’ah compliant financial markets and Lender of Last Resort facility. The requirement that transactions have to be underpinned by assets has resulted in complex transactions as well as corporate structures that include non-financial corporations in the groups.

These differences raise specific policy issues in terms of regulation and supervision, consumer protection, monetary policy and liquidity management, and tax policy. To deal with some of these issues, jurisdictions have cooperated to put in place specialized institutions to develop regulation standards (IFSB), governance, auditing and accounting standards (Accounting and Auditing Organization for Islamic Financial Institutions), financial markets instruments (International Islamic Financial Markets) and short-term liquidity infrastructure (International Islamic Liquidity Management Corporation).

Sukuk (Bond)

Sukuk, the Islamic equivalent of bonds, are similar to asset backed securities and differ from conventional bonds in a number of ways. Whereas a conventional bond is a promise to repay a debt with a specified interest rate, Sukuk have to be structured in a manner that ensures that there is an underlying asset, the principal amount is not guaranteed and the return to investors is linked to the performance of the underlying assets.

Sukuk assume a variety of structures. They can be issued as asset backed where investors have a claim on the underlying asset or asset based where the claim is on the originator and not the underlying assets. Since Sukuk issuance began to accelerate, a number of different structures have developed, including partial ownership in receivables, lease-based and profit and loss sharing partnerships as well as convertible and exchangeable trusts.

Sukuk could be well suited for infrastructure financing, but there are also important implications for financial stability as well as specific issues in terms of consumer protection that deserve attention. Sukuk resemble Public Private Partnership financing whereby investors finance the assets, and then own them which leads to real securitisation and, finally, transfer them at maturity to the government.

Decadence of the existing financial system in Nigeria

In Order to reduce the poverty level in Nigeria, The Central Bank of Nigeria Introduces the Microfinance banks (MFBs) in the year 2005. According to the CBN, “Robust economic growth cannot be achieved without putting in place well focused programmes that increase assess of poor and low income earners to factors of production, especially credit. Microfinance is about providing financial services to the poor who are traditionally not served by the conventional financial institutions”

However, against the motive of their establishment, these microfinance and most of the conventional banks in Nigeria provides credit facilities to their customer and charges interest up to 21% on the borrowed funds. This is possible by quoting a relatively small nominal interest rate to lure the customer, but by way of compounding (although, using reducing balance method) and repayment structure of the loan (say monthly or quarterly) will make the effective interest rate to be about the range stated above.

Borrowers of such facilities are left with overload of debt burden as there are not so many businesses that can generate such return on investment considering the high input cost and the current economic situation of the Country.

 Prospect of Islamic Finance in Nigeria

The wide acceptability of Islamic finance in Nigeria is evident by the floating of ?100bn Sukuk bond by the Federal Government recently to finance some infrastructural project, which was oversubscribed by ?5bn.

In order to fund our deficit in infrastructure, Nigeria needs to spend about $14bn annually, this could be source from Public Private Partnership, Islamic finance and all other sources of funds that will not increase the debt burden of the Country.

Other benefits of Islamic finances includes:

Reducing the size of unbanked

According to the Central Bank of Nigeria in 2011, when those that had financial services from the informal sector such as savings clubs/pools, Esusu, Ajo and money lenders were included in the survey, the total access percentage was 53.7%, which means that a total of 39.2 million adult Nigerians (46.3%) of Nigeria’s population were financially excluded in 2010, (five years after the launching of the microfinance policy). Going by the above statistics, there is existence of an untapped business potential in the Nigerian banking sector which Islamic finance will help address.

According to the Central Bank of Nigeria in 2011, when those that had financial services from the informal sector such as savings clubs/pools, Esusu, Ajo and money lenders were included in the survey, the total access percentage was 53.7%, which means that a total of 39.2 million adult Nigerians (46.3%) of Nigeria’s population were financially excluded in 2010, (five years after the launching of the microfinance policy). Going by the above statistics, there is existence of an untapped business potential in the Nigerian banking sector which Islamic finance will help address.

New sources of foreign direct investment

Islamic finance can generate more inflow of FDI which is key to a sustainable economic development.

 Improve regional competitiveness

The introduction of non interest bank is expected to engender a wave of healthy competition in the banking industry with a possible concomitant reduction of interest rates, which would have a salutary impact on the economy.

Capital Market diversification

Islamic finance will help diversify the capital market and propel the economy away from interest modelled financial system to a risk and profit sharing model.

Challenges

Regulatory challenges are another issue facing Islamic banking in Nigeria. Banking regulations in Nigeria works on a market-driven model. and the institutional and legal framework for the banking system in Nigeria are structured in line with the conventional financial system, and the enforcement of Islamic banking operation in the court of law would pose a problem without implementing Islamic laws in Nigerian legal system.