Saturday May 3 2014

Let’s understand principles of Islamic banking before it’s adopted

By Ian Mutibwa

The Minister of Finance urged Legislators to quickly enact a law that deals with Islamic banking so that this new phenomenon can be realised in Uganda.

The people in Uganda are also eagerly waiting to engage in this new concept of Islamic banking that has “interest free loans”. The speculation in my opinion is how this new system shall differ from the already existing banking and whether it offers better opportunities than the current banking systems in Uganda.

Islamic banking is essentially a system that is premised on the teachings, doctrines and the principles of the Koran. It emphasises equality and justice and above all morality even whilst doing business.

Islamic banking is also widely interpreted as the banking system where “no interest” is charged on loans or given on deposits as opposed to the modern capitalistic banking system where interest on loans is the basis for liquidity in a bank and interest on deposits attracts the consumers to financial institutions.

Many economists indeed argue that interest is the reward for money. Where money is invested, or used by another the return is interest. John Maynard Keynes (1883-1946) argued that money is the most liquid of assets and that interest is the price paid for loss of liquidity. Interest is, therefore, an important aspect where a bank is to make money and where individuals or corporations are “forced” to make deposits in the bank.

This, therefore, makes me ponder as to how this interest free system actually works. Is it an utopia of sorts and simply idealistic and can never work or can it be feasible even in Uganda? To answer this question, my research led me to digging up history of Islamic banking and how they survive in this ever capitalistic world.

Islam does not allow interest (riba) to be charged on money and Islamic banking does not allow interest on deposits or loans. However, it allows for reward for work and sharing of loss.
The concept of Islamic banking is simple and it is easier to describe than define, you take two persons for example, one has money to lend out and the other the idea to invest the money.

The one who lends the money gives it without any interest on return, but the one who receives it agrees at the onset that he will work with the money, make profit and then share the profit with the one who gave the money in the first place at an agreed percentage. In this way the owner of the money shall have the principle back and also a share of the profit in the investment made.

The loss is suffered by both parties as well. When there is a loss, the owner of the money shall suffer the loss as much as the investor. This concept works both for deposits in the bank, in which case the bank becomes the investor sharing profits in an agreed percentage with the depositor, and for the bank where it lends money to persons.

Islam argues that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss too.

As long as the owner of money is willing to become a shareholder in the enterprise and expose his money to the risk of loss, he is entitled to receive a just proportion of the profits and not merely a nominal share based on the prevailing interest rate.

Therefore, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as it is assumed. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking; it is expressed as a ratio of profit.

In my opinion, the aspect of Islamic banking works best in an environment of upright morality and lawfulness and since it is a Sharia concept, strict rules of Sharia should apply where there is breach of the agreement to lend and invest one’s

While Parliament is under pressure to produce a law regulating Islamic banking, these aspects need to be looked at in detail and ensure that they are well captured so that the rather idealistic banking can be realised.