For almost a decade, there has been a global increase in demand for Islamic financing techniques in transactions. According to some, the Middle Eastern wealth boom and entrepreneurs’ desire to obtain financing from investors in these regions are both related to the influence of sharia-compliant financing practices.
In this work, the guiding principles of Islamic finance are examined and contrasted with traditional Nigerian corporate financing practices.
Nature of Islamic finance
Islamic finance is a system of financial operations that complies with Sharia’s guiding principles. For the development of a sound society, the Sharia provides doctrines that support ethical business practices, just transactions, and overall financial balance. By encouraging the investor to use money to enhance the general well-being of society, Sharia’s guiding principles foster inclusivity, partnership, loyalty, and unity.
The Sharia has five main goals: the preservation of religion (Deen), the preservation of life (Nafs), the preservation of family (Nasl), the preservation of intellect (Aql), and the preservation of wealth (Maal). The idea of wealth preservation (Maal) is central to Islamic finance. For instance, since gambling has an uncertain profit potential, the sharia forbids it, to protect your wealth.
Contracting under Islam
Sale, loan, and lease are the three main components of contracts in Islam. In conventional business practice, these three contracting elements have comparable requirements and definitions. According to Islamic finance, a sale results in the ownership of an asset, a loan results in the ownership of a debt, and a lease results in the ownership of a usufruct.
Some practices are permitted and others are forbidden by the Sharia. Complete adherence to these practices is necessary for Islamic finance. Some of these actions include:
- All requirements of the sharia doctrine must be followed. One cannot modify the doctrines of Sharia under contract while applying Islamic finance; for example, the Sharia position on inheritance cannot be changed under contract.
- The default rule, which states that the sale is complete after the buyer or seller departs from the location even when goods remain with the seller, is applied in Islamic financing.
- Deposits or collateral are allowed when transacting, and the owner of a leased property can place some restrictions on the use of the property.
There are also prohibitions under the Sharia when contracting. These prohibitions must be avoided for the contract to be sharia-compliant. These prohibitions are:
- Having two transactions in a single contract, for instance, a sale and a lease or a loan and a sale, violate the principles of sharia. The sale and lease transactions must be covered by separate contracts for this to happen. In light of this, hire-purchase transactions are not permitted under Sharia law because they combine a lease and a sale transaction by buying an asset while renting it at the same time.
- Interest-bearing loans are prohibited by the Sharia. Islamic finance allows for the offering of loans with no interest. For non-Muslim business owners who use Islamic finance techniques for financing, this is one of the biggest attractions.
- Additionally forbidden are contracts that depend on the fulfillment of another contract. For instance, a creditor is not allowed to grant a loan to a debtor in exchange for the debtor selling his car to the creditor.
- You cannot sell, lease, or loan out an asset that was not yours at the time of the transaction.
- You cannot trade money for money. This is perhaps the most controversial of all the prohibitions. Under the Sharia, money is not seen as an asset but as a means to acquire an asset. Under Islamic finance, you can only exchange money for an asset or vice versa. Transactions that allow one to profit by trading money are prohibited. For instance, giving out loans with interest amounts to making money by selling money, is prohibited. This prohibition is perhaps the foundation of Islamic finance and the conflict it has with conventional banking practices.
Islamic banking and conventional banking
Banking practices in Islam and those in conventional banking differ in a variety of ways.
One of such significant differences is the way money is viewed. The traditional banking approach views money as an asset that can be bought, sold, or rented for a profit. Rather than trading assets, conventional banks typically exchange money with investors who trade assets and pay interest on the money received from the banks. Traditional banks also earn money by allowing customers to transact money in exchange for fees that are paid to the banks.
Contrarily, money is only considered a means of exchange in Islamic banking. Generally, money cannot be used as an asset, sold, rented, or bought for profit. Assets can be made out of money, and then they can be sold.
In addition, conventional banks deal with money and documents rather than goods. Banks are not required to exchange goods for money in conventional banking. Islamic banking focuses on the exchange of goods and documents; under this system of finance, banks can buy and sell goods for money.
Relevant Islamic Banking Practices
- Musharakah (Equity): The musharakah is a profit-and-loss-sharing form of partnership. Here, two or more parties finance a project with a shared ratio for profit and loss. Under the musharakah, the profit-sharing ratio can be negotiated, but the loss-sharing ratio is fixed to the percentage donated; for instance, if investor A provides 60% and investor B provides 40% of the investment sum, the profit-sharing ratio can be negotiated at 50% for each, meaning both parties share equally when there is a profit, but when there’s a loss, the ratio cannot be negotiated, meaning investor A loses 60% and investor B loses 40%.
- Diminishing musharakah: is perhaps one of the most vital techniques used by Islamic banks to fund transactions. It involves one party gradually buying off the asset from the other party until the latter party acquires ownership of the complete asset. For instance, if Mr A intends to purchase a property for $100,000, the Islamic bank would provide funding for 80% of the property’s purchase while Mr A would provide 20%. Mr A can then use the property and pay the actual rental value to it; if the rent is $10,000 annually, the bank gets 80% of the rent at $8000 annually, while Mr A keeps 20% of the rent. Mr A can then gradually purchase the bank’s equity in the property. If Mr A pays $30,000 to the bank in the first year, the bank’s equity drops from $80,000 (80%) to $50,000 (50%), annually. The following year, Mr A would pay rent at 50%, which is $5000 to the bank. This process continues until Mr A completes the payment of $100,000. In the end, the Islamic bank gains from the actual rental payment, which differs from the payment of the property itself.
- Mudarabah: is a profit-and-loss-bearing contract between an investor and a manager. Here, the investor provides the entire investment and offers a percentage of the profits to the manager for his expertise in managing the transaction’s success.
- Sukuk: This is a method of public bond offering in Islam. The holder of Sukuk shares in the investment’s profits, as opposed to traditional bonds, which guarantee to pay bondholders interest for their loans.
Following the increase in the number of Muslims living in various countries around the world, the demand for Islamic finance is anticipated to increase even further. Islamic finance is undeniably here to stay in the current global order. It is impossible to overstate the importance of Islamic finance in Nigeria. With Nigeria having one of the world’s largest Muslim populations—over 80 million Muslims—there is undoubtedly a high demand for sharia-compliant principles.
Frequently Asked Questions (FAQs)
The two main sources of Islamic finance which are based on the sharia law are the Qur’an and the Sunna. The Qur’an is the holy book, and the sunna is the body of knowledge derived from the teachings of the Prophet Muhammad as preserved in the Hadith literature. Other sources include Ijtihad, which contains legal interpretations, and Ijma, a text of agreed principles by all and is not open to interpretation.
No, this is due to the uncertainty of insurance transactions. The sharia-compliant variant to insurance is Takaful.