Explainer: How does Islamic banking work?

Jul 11, 2018|Aisha Salaudeen

Islamic banking or finance is any banking or financial activity that follows the principles of Shariah, a code of conduct that guides Muslims in economic, social and political matters.

Islamic banks work like conventional banks, except they have to obey specific Islamic principles. Perhaps the most popular principle is that interest is not allowed. Shariah mandates that all profit must come from work, and lending money to someone who needs it does not count as work. Under Islamic Finance, money is considered purely as a medium of exchange and store of value and cannot on its own, create more money – which is what happens with lending. Instead, a bank or financial institution has to provide some service to earn its profits.

Therefore, instead of conventional accounts with interest rates, Islamic banks provide services and accounts that offer profit or loss sharing mechanisms.


How do they do this?

Let’s say I want to start a bread business, but I don’t have enough capital to build a bakery.  I can take my proposal to an Islamic bank and convince them to invest in my project. The bank then funds my business, whether in cash or through assets, while I run the enterprise. I then split the profit from the bakery with the bank at a pre-agreed ratio, and if I make a loss, the bank loses its investment.

So, it’s sort of a win-win situation. The bank provides me with capital and generates earnings from sharing my profit, I kick-start my business and expand the enterprise with a partner ready to share my loss. This is called Mudarabah.

Shariah does not permit projects with high uncertainty, so both parties in the contract must disclose all possible risks and relevant information in the contract. With my bakery, for example, I have to outline all the risks that could prevent me from fulfilling my dream – from real estate concerns to flour prices – while the bank must inform me of all the strings attached to facilitating my investment.

This differs from conventional banking. If I approached a bank to fund my business, I would have been granted a loan with a predetermined interest rate. Let’s say they invest ₦1 million in my bakery; the bank would get its interest payments whether I succeed or not. I bear all the risk, unlike in Islamic finance where the risk is shared.  

Islamic financial institutions also generate profits through Murabaha. Under Murabaha, an Islamic bank purchases an asset on behalf of a client, e.g. a car, and resells that asset to the client at a marked-up price. Usually, the client pays for the asset in instalments. Again, this differs from a conventional loan where the bank lends money to clients to buy the asset and charges them interest on the loan amount. With Murabaha, the bank finds the product, buys it and resells to the client with a markup.

Under Islamic finance, the bank is obligated to mention the cost incurred in the initial purchase of the car and how much is being added to the initial price.

Islamic banks tend to favour Murabaha contracts over Mudarabah contracts as the income from the former is guaranteed.


Islamic Banking in Nigeria

Islamic Banking is practised in close to 70 countries. The United States, Malaysia, Kenya, Nigeria, etc. all practice the alternative form of banking. Even global banks like HSBC and Barclays have windows for it too. In Nigeria, Islamic Banking was introduced by the Central Bank (CBN) in 2011, in an effort to diversify the country’s financial system by introducing sharia-compliant products.

One example is the Sukuk, a Shariah-compliant bond. Like a regular bond, the issuer sells ownership certificates to investors, but these certificates aren’t just bond certificates (or IOUs) but are certificates of part-ownership of the asset bought with the sukuk proceeds. It is structured to comply with Shariah by paying profit (not interest) on a tangible asset like land. Sukuk holders, therefore, receive a portion of the earnings generated by the asset.

In 2017, the Nigerian Government issued the first sovereign Sukuk and raised ₦100 billion for the rehabilitation and construction of 25 priority roads across the country. The Okene bypass and the Eastern Kaduna bypass projects are being financed by the Sukuk, showing the usefulness of the product in real life.


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