Non Interest Banking: Facts And Summary
A non interest banking is the type of banking that do not take or give interests on assets and operating basically under the whim and caprices of sharia law. Each Islamic bank has a sharia board made up of sharia scholars as well as financial expats who are responsible for determining what activities are and are not Sharia compliant.
Non interest banking is majorly based on two main financial principles. Firstly, investments is to be made in the privet sector through interest free financing. Secondly, the development of financial instruments is to be done on the basis of profit and loss sharing as well as risk sharing.
The law guiding the operation of non interest banking considers interest as an unjustified increase of capital, with no effort made to earn it, and as such it is considered illegal and illicit thereby renders the earnings from false value.
It is important to know that argument about the prohibition of interest in non interest banking are still intense. Some of the critical ones that are against are; that interest rate have no moral foundation, that abstinence from consumption is not a justification of rewards, and that there are risks justifying the supplement of paying for capital lending if the loan is guaranteed.
In addition to the prohibition of interest payments, the law guiding non-interest banking treats money strictly as a medium of exchange. Also the creditor/debtor relationship is defined differently than in the conventional financial institutions. the provider of funds becomes a partner in a project thereby assumes the risk activity with the entrepreneur and shares profit as well as losses.
Moreover, the concept of interest is based in the believe that the Qur’an bans all interest rates, regardless of its rate or form. In fact, what the Qur’an bans is riba, the practice of doubling the debt of a borrower unable to make restitution on schedule, including both the principal and the accumulated interest.
Riba is perceived to push defrauders into enslavement and as such considered an acute source of social friction. Whatever the notion of the virtues of risk-free returns, the crux of the argument is that profit is legitimate only as a reward for risk.
Non Interest Banking
Literature on the non interest banking and monetary policy is not quite rich especially in Africa and in Nigeria in particular where the operation of non-interest banking is at a preliminary stage.
However, it is imperative to mention a few especially from countries which share similar developmental characteristics with Nigeria. Empirical assessment on the merit of the interest-free banking system where initiated by Darrat (1988), the study showed that the banking system in Tunisia is more stable without interest bearing assets than if the assets were to exist.
More recent studies by Darrat (2000) and Kia (2001) provided further empirical evidences on the effectiveness of the interest-free monetary and banking system in Iran. These studies found that both short and long-run interest-free money demand functions are stable and their coefficients are invariant with respect to policy and other exogenous shocks.
Kia and Darrat (2003) compare the demand equations for money and profit-sharing deposits and found that the demand for profit-sharing deposits has the most stable and policy invariant function. The study further suggested that the profit-sharing deposits could represent a credible instrument for monetary policy making in Iran.
Samad (1999) and Kaleem (2000) provided empirical support for the stability of the non-interest monetary instruments in a dual banking system in Malaysia. Kaleem (2000) examines the Malaysian data spanning the period 1994 to 1995 and found that non-interest banking is less crises-ridden compared with the interest bearing conventional banking to its asset-linked element.
Despite the support in favour of non-interest banking framework as a better tool for monetary policy, Some studies disagree on the basis that more detailed aspects of the relationships between the interest-free banking and various aspects of financial risk reveal some concerns.
Baldwin (2002) showed that there is a general lack of awareness in adopting the best risk management practices in the countries that concentrate on the supply side of the monetary policy due to an erroneous belief that a non-interest bank, by virtue of its interest-free nature, is not subjected to the interest rate fluctuations.
Rosly (1999) found that non-interest bank in Malaysia are at disadvantage compared to the conventional banks especially during the period of increase in market interest rates. Nothing that, while the conventional banks could reap higher profits from rising interest rates, non-interest bank face negative fund gap since interest-free financing is based on fixed rate, and that deposit liabilities are bench-marked against the prevailing interest rates.
Kaleem and Verhoeven (2005) examined whether interest-free banking institution in Malaysia are subject to credit risk, interest-rate risk and liquidity risk. The study found that while the deposit money banks with interest-free financing have significantly lower risks and liquidity risks, they have significantly higher interest-rate risk than the banks with non-interest financing.
Another study by Kaleem and Isa (2006) reveal another weakness of the interest free monetary system particularly in a dual banking system such as in Malaysia they studied. They found that the financial market set up operating at the time of conducting the study was not in favour of the interest-free banking system because it enables the conventional banks to take advantage of the arbitrage opportunities provided by the dual banking system.
In trying to established a level operating ground for both system, it should be gotten clear that despite the different philosophical foundations governing the two systems, they are both subject to the teams macroeconomic conditions.
Bacha (2000) relates that nevertheless, the differences of which one is better than the other may lie in the profile of the customers that subscribed to both banking systems. He further suggested that there is always a possibility of switching between the two systems. Also from the customers point of view, depositors can take advantage of the arbitrage that arises from the rate differentials between the two systems.
Challenges Of Non-Interest Banking
1. The absence of appropriate control measure of the intermediate objective by the Central Banks may detract from the target of consideration monetary aggregate as an objective of monetary policy.
2. The prohibition of interest payments treats money strictly as a medium of exchange. Also, the creditor/debtor relationship is defined differently than in the conventional financial institutions. This makes the concept to look abstract.
3. Shortage of human capital: The requirements that the members of the Shariah Committees and the Sharia Advisory Council must be academicians and Sharia expats in Islamic banking and finance is a challenge, and more worrisome is the fact that even the few ones are advanced in age. There is also dearth of scholars with the combined knowledge of Sharia jurisprudence and modern economic finance. This affects the efficiency with which a verdict on new non-interest products, since new products have to be cleared. by Sharia scholars before they can be adopted.
4. There is no generally acceptable accounting and auditing reporting standards for non-interest banking. This makes it difficult to compare the performance of non-interest banks and financial condition of different banks.
5. The absence of Sharia complaint liquidity management instruments would make the job of the monetary authority more cumbersome.
6. The challenge of image: Many are skill skeptical on the operation of non-interest banks as some view it as a religious affair, while others link it to terrorism.
7. There is lack of appropriate non-interest based investments for financial budget deficits.
8. There is general lack of awareness of what a non interest-based investment entails.
9. The activity of the non-interest banking precludes the use of discount rates and open market operation to influence liquidity. These tools are considered to be one of the best monetary policy tools especially in this age of globalization and financial engineering.
10. Depositors of funds are treated as if they are shareholders in non-interest banking as such implementing it in an economy that has experience long regime of the opposite would present some challenge. Depositors under the non-interest banking framework are not guaranteed of the nominal value of a predetermined rate of return on their deposits.
11. Financial market operations would not be in favour of the interest-free banking system because it enables the conventional banks to take advantage of the arbitrage opportunities provided by the dual banking system.
12. Another challenge of non interest banking is that there are no firm rule guiding the determination of profit/loss which is a cardinal element of non-interest financing. This may create conflicts of interest.
Major Things To Know About Non-Interest Banking
1. Musharakah: The literal meaning of Muaharakah is sharing. It is a joint enterprise that is form for the purpose of conducting business in which all the partners share the profit/loss accrued from the business according to a ratio of contributions. Thus corresponds closely to equity market in which shares can be acquired by the general public. It has rules of management that includes a profit determination/distribution, reviews of the contract as well as termination.
The Muaharakah has a certificates which is usually used as a tool as a tool of monetary policy as it makes possible for all people to invest in great and profitable projects, and at the same time help Central Bank to control the volume of money flexible enough to bring stability in goods and money market when it wants to execute monetary policy.
2. Mudarabah: This is a kind of business partnership where one partner gives money to another for investments in profitable legal ventures. The fund supplier is called “Rabb-ul-Mal” while the fund manager is called ‘Mudaraba’. The major difference of Mudarabah and Musharakah is that Mudarabah is valid for single individual/entity as partners while the later involves several partners. The Mudaraba can be different forms ranging ranging from a restricted Mudaraba to a non-restricted Mudaraba. The rules of engagement and management is as enshrined in the Islamic jurisprudence.
3. Murabahah: (Cost-plus Financing). This is a form of business transaction that involves the sale of goods at a price that includes a profit margin agreed by the parties involved.
4. Ijara: Ijara is a form of transaction that operates as lease with an option to buy. The banks normally buy the property and lease it to a client and the client pays for both the purchase price and the rent price.
5. Qard: Qard is an interest-free loans that is given for a fixed period of time on a goodwill basis and the borrower is only required to pay the principal of the loan amount only.
6. Hibah: Hibah which means gift; is a willingly payment made as appreciation in return for a benefit received. The gift can also be used by banks to absorb savings from the customers.
7. Wakalah (Agency): Wakalah is a business arrangement where individuals or organizations authorize another individual/organization to act on behalf to execute a specific business task.
8. Ghara: Ghara is an unclear fact or condition. This is highly prohibited in non-interest banking as it renders business transaction null and voild.
9. Wadlah (Safekeeping): Wadlah is a business arrangement where one deposits cash or assets in a bank for safekeeping. The bank guarantees the safety of the item kept and charges a fee for looking after the item. The customer is allowed to withdraw the item at any time he/she wishes.