Islamic Banking: All you need to Know

by Business Times
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On Friday 08th September 2023 the Bank of Uganda issued the first-ever Islamic Banking License to Salaam Bank Limited. This follows President Yoweri Museveni’s signing of the Financial Institutions (Amendment) Act 2023 in August, giving the green light to investors to set up full-fledged Islamic banking facilities.

Below are the answers to Frequently asked questions about Islamic banking.

What is Islamic Banking?

Islamic Banking is the type of banking that follows the principles of Shari’ah. This implies that Islamic Banking must uphold the elements permitted and eliminate those prohibited by Shari’ah. The dos and don’ts for Islamic Banking are; 1) Prohibitions: Islamic Financial transactions must not entail elements prohibited by Shari’ah namely payment of interest, products with uncertainty, gambling, as well as the financing of activities that are considered harmful to society (say pornography). 2) Fairness: Islamic Banking requires parties to honour principles of fair treatment and the sanctity of contracts. 3) Real Economic Activities: Transactions must be backed by real assets / economic activities. 4) Risk sharing: There must be sharing of risk and hence profits and losses in economic transactions.

Is Islamic Banking meant for Muslims only?

No. Islamic Banking’s value proposition lies in its key tenets geared towards promoting fairness, transparency and direct linkage with economic activity, which appeal to all individuals regardless of their religious affiliation.

Since in Islamic Banking, charging of interest is prohibited, how do Financial Institutions offering Islamic Banking products make money?

Financial Institutions offering Islamic Banking products make money through earning profits on trading activities that they engage in, rental income from properties leased to customers and by sharing profits accruing from the projects in which they invest in partnership with the customers.

Since in Islamic Banking, the Financial Institution and the customer share losses, doesn’t it disadvantage the parties involved in a transaction in the event of underperformance of a financed project?

No, in practice, Islamic Financial Institutions create reserves called Profit Equalization and Investment Risk Reserves, which are used as a cushion against losses.

How do the Profit Equalization and Investment Risk Reserves work?

The Profit Equalization Reserve is created as an appropriation from profits earned on an investment before the allocation of profits attributable to the Investment Account Depositor and the Financial Institution. In addition to cushioning Investment Account Holders (depositors) against losses, the Profit Equalization Reserve can be used for enhancing dividend payouts to shareholders if deemed necessary by the management of the Financial Institution. On the other hand, the Investment Risk Reserve is appropriated out of the profits attributable to Investment Account Depositors after deducting the Financial Institution’s profit share. It is solely used to cushion losses, which erode the profits payable to Investment Account Depositors. The customer agrees in advance, in the contract that regulates their relationship with the Financial Institution, on the proportion of their income that may be appropriated to each of these reserves.

Do Islamic Financial Institutions accept customer Deposits like their Conventional counterparts?

Yes, Islamic Financial Institutions licensed by the Central Bank shall accept deposits from customers. The Deposits take on various forms; Savings and Current accounts, which are similar to those in Conventional Banking, and Investment Deposits that are akin to Time Deposits but with different modalities.

Types of Deposits:

 1) Current and Savings Accounts: Current and Savings Accounts in Islamic Banking are similar to those in the Conventional Banking setup. However, while in Conventional Banking some Financial Institutions pay interest to Savings account holders subject to certain conditions; in Islamic Banking these accounts do not earn a return. They are held by the Financial Institution for safe custody.

 2) Investment Accounts: These are akin to Time Deposits in Conventional Banking, and they take on two forms;

a) Unrestricted investment accounts in which the Depositor does not specify the projects in which the Financial Institution should invest their funds, and

 b) Restricted investment accounts where the customer specifies the projects in which the Financial Institution should invest their funds.

Investment Account Depositors share the profits and losses arising from the investments undertaken with the Financial Institution. However, in order to remain competitive, Islamic Financial Institutions compensate depositors for any losses that may arise from an investment using the Profit Equalization Reserve described above.

Do Islamic Financial Institutions offer loans to customers?

Yes, Islamic Financial Institutions do offer two major types of loans to customers under various contracts;

1) Debt-like financing structures; where a Financial Institution buys an asset on behalf of the customer and sells it to the customer at a markup. Or, a Financial Institution leases an asset to the customer, which works like the leases in Conventional Banking. These include:

a) Murabahah (Sales Contract at a Profit Mark-up): Under this contract, the customer (Borrower) applies to an Islamic Financial Institution for financing to purchase an asset, say a car. The Financial Institution must purchase the car and own it first before reselling it to the customer at price higher than the cost price resulting in a profit to the Financial Institution.

b) Leasing contracts: Islamic Financial Institutions offer leases to customers, which are similar to the leases in Conventional Banking.

2) Profit and loss sharing (Partnership) contracts; where the Financial Institution and the Customer join in a partnership to co-finance a project and share the profits generated from the project based on a pre-agreed profit-sharing ratio. These include:

a) Mudarabah (One Silent Partner and one Active Partner): This is a partnership arrangement in which a Financial Institution provides funds to a customer/borrower for investment in a business venture. The two parties share the profits accruing from the investment in accordance with a pre-agreed ratio, but any losses are borne by the Financial Institution, except where it is confirmed that the losses arose due to the borrower’s negligence, in which case the borrower bears all the losses. In this contract, the Financial Institution is mandated to engage in the day-to-day management of the business/project.

b) Musharakah (Two Active Partners): In this contract, the Financial Institution and the Customer (Borrower) both contribute funds towards a business venture, both parties are expected to participate in the day-to-day management of the business venture and share the profits arising from the investment in accordance with an agreed profit-sharing ratio, while the loss is distributed in proportion to the share of each in the total capital.

Note: Under the partnership contracts, the Borrower gradually buys out the Financial Institution’s stake in the business venture in accordance with an agreed schedule. Based on the above contracts, Islamic Financial Institutions can structure very many contracts.

Do Islamic Financial Institutions require borrowers to provide collateral for funds granted?

 Yes, in a Murabahah (Sales Contract at a Profit Mark-up), the asset being financed acts as security until the customer (borrower) repays the Financial Institutions funds in full. Similarly, under Profit and Loss Sharing (Partnership) contracts, the customer is required to pledge collateral such as tangible assets, guarantees, and insurance.

How do Islamic Financial Institutions determine the markup charged to customers?

Islamic Financial Institutions calculate their profit markup by using available benchmarks such as the ruling market rates as do Conventional Financial Institutions.

Isn’t markup the same as interest but simply renamed?

No. The prohibition of interest lies not in the amount of the mark-up or its similarity or equity with interest, but rather in the method of its generation. The key point is that the markup is not self-generating (i.e., it does not arise out of money on money like interest, but it is generated as a result of an absolute sale of a real asset).

Which Institutions will be authorized to offer Islamic Banking?

Islamic Banking can be offered by fully-fledged Islamic Financial Institutions or by conventional Financial Institutions through the establishment of Islamic Banking Windows, Branches, or Subsidiaries.

Can Islamic Banking co-exist with Conventional Banking?

Yes, Islamic Banking can co-exist with Conventional Banking. Indeed, in most jurisdictions, where Islamic Banking is practiced, the Banking sector is comprised of both Islamic and Conventional Financial Institutions.

How does Islamic Banking differ from Conventional Banking?

Unlike Conventional Financial Institutions, Islamic Financial Institutions are allowed to engage in trade activities and in partnerships with customers to co-own and manage a business venture. In addition, Islamic Banking transactions are backed by real assets or economic activity, which is not the case with Conventional Financial Institutions.

Will Islamic Banking be subjected to similar regulatory standards as is Conventional Banking?

Yes, the Bank of Uganda will license all Financial Institutions that wish to conduct Islamic Banking business under the same law that governs conventional banks, the Financial Institutions (Amendment) Act, 2023.

Is there a Demand for Islamic Banking in Uganda?

Yes. Bank of Uganda’s decision to propose amendments to the Financial Institutions Act of 2004, to facilitate Islamic Banking was in response to the market demand. Investors submitted applications to operate Islamic Financial Institutions and Conventional Banks expressed willingness to offer Islamic Banking Products. The Financial Institutions (Amendment) Act, of 2016 incorporated substantive provisions of Islamic Banking and most importantly lifted the prohibitions to Islamic Banking that existed in Sections 37 and 38 of the 2004 Banking Act. Section 37 of the 2004 Financial Institutions Act prohibited Financial Institutions from directly or indirectly engaging in Trade, Commerce, and Industry while Section 38 of the same Law prohibited Financial Institutions from acquiring immovable property that is not intended for use in conducting their business. The aforementioned Sections were an impediment to Islamic Banking since engagement in Trade, Commerce, and Industry as well as ownership of immovable property are at the heart of Islamic Banking.

How Would Islamic Banking benefit the Ugandan economy? Islamic Banking is expected to enhance access to banking services (financial sector widening) and increase the range of financial products offered in the sector (financial sector deepening). In addition, Islamic Banking through the profit-sharing contracts between Financial Institutions and Customers provides an alternative to the interest rate-based Banking regime. Further, the notion that Islamic Financial Institutions are backed by real assets / economic activity, creates a direct link between the financial markets and economic development.

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