Islamic business finance: what is it and how does it work?

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Page written by Chris Godfrey. Last reviewed on October 30, 2024. Next review due 2025.

Islamic finance is the fastest growing sector of international banking, with Islamic institutions based in Nigeria holding assets over ₦5.4 billion. With shared profit and loss loans, zero interest charges, and a commitment to supporting non-harmful enterprises, Islamic finance is quickly becoming a major force in Nigerian business lending. Read on to find out more about this different kind of financing and to discover if it’s right for you.

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What is Islamic finance?

Islamic finance is governed by Shari’ah law and the tenet that money has no intrinsic value but is a tool to smooth the exchange of products and services – a lubricant to simplify trade. This belief also states that it is wrong to make money from money – as we see with interest charges on typical Nigerian bank accounts and loans. Because of this, Islamic institutions do not charge interest on Shari’ah-compliant loans or pay interest to customers who deposit money into a current or savings account with an Islamic bank. Nor will they support any financial activity that Shari’ah says is harmful – this would typically include things like tobacco, alcohol, and gambling.

How does Islamic finance work?

Because Shari’ah does not permit the charging or payment of interest on loans or deposits, Islamic institutions earn and pay profits by acting as agents or partners to their customers, (those seeking loans, and those depositing cash). The systems work like this:

Example of a Shari’ah compliant loan
You wish to buy a commercial property with a loan:
The bank can directly buy the property you want. Then they sell it to you at a profit and let you pay them back in instalments. This is called a ‘murabaha’ contract, (because the bank is buying the property and selling it to you at a profit). Or you could buy the property jointly with the bank, in what is called a ‘musharakah’ (partnership) contract. Over time you pay the bank back for its share of the property until you own 100%. In both cases, the bank charges you extra to cover their costs and to reflect the fact you’re using a property they partly own.

Example of Shari’ah-compliant bank payments to depositors
You pay money into a current or savings account at an Islamic bank:
A Shari’ah-compliant current account does not pay traditional interest. Instead, in return for having ready access to your money, the deposit you give the bank is used as an interest free loan. This loan is known as a ‘qard’.
Savings accounts also do not earn traditional interest. Instead, the bank will invest the money you deposit in a Shari’ah-compliant opportunity and will pay you part of any profit they earn. Depending on what your funds are invested in and how the profit is worked out, this might be called a ‘wakalah’ (where the bank acts as your agent) or a ‘murabahah’ (where a bank buys and trades in commodities to earn a profit).

What are the four components of the Islamic financial system?

The Islamic financial system is based on four prohibitions:

Paying or charging of interest (riba)
Islam considers lending with interest payments as an exploitative practice that favours the lender at the expense of the borrower. According to Shari’ah, interest is usury (riba), which is strictly prohibited.

Investing in businesses involved in prohibited activities (haram)
Some activities, such as producing and selling alcohol or pork, are prohibited in Islam. The activities are considered haram or forbidden. Therefore, investing in such activities is also forbidden.

Speculation (maisir)
Shari’ah strictly prohibits any form of speculation or gambling, which is called maisir. Therefore, Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event in the future.

Uncertainty and risk (gharar)
The rules of Islamic finance ban participation in contracts with excessive risk and/or uncertainty. The term gharar measures the legitimacy of risk or uncertainty in investments. High risk contracts are forbidden.

In addition to the above prohibitions, Islamic finance has two more important principles:

Material finality of the transaction
Each transaction must be related to a real underlying economic transaction. It cannot be money making money off money.

Profit/loss sharing
Parties in a contract in Islamic finance must share any profit or loss and the risks associated with the transaction. No one can benefit from the transaction more than the other party.

Is it Halal to get a loan from a bank?

Yes, providing the loan complies with Shari’ah law – which forbids the charging or payment of interest. (See the definitions of musharakah, murabaha, and ijarah below for more details).

Are business loans allowed in Islam?

Yes. Although there are differences from the standard business loans offered by non-Islamic lenders.

Firstly, Islamic finance dictates your business should be allowed (halal) and not be engaged in any activity forbidden by Shari’ah law.

Secondly, your business must provide some form of benefit to the community at large, rather than just making a profit.

What are the benefits of Islamic finance?

The key benefits of Islamic finance are:

No interest is charged on Shari’ah-compliant loans. This removes borrower concerns about rising interest rates and escalating payments.
If the loan is to purchase a hard asset, such as plant or machinery, the Islamic institution will typically apply a flat profit on the cost price of the asset as they buy it and sell it on to the lender. This profit has been agreed in advance and because it is fixed, the borrower has full knowledge of the cost of the deal with no worries about fluctuating interest rates.
Shared profit and loss: When you obtain a loan from a conventional bank and things go wrong, the lender’s main priority is to recover their money, even if that means leaving the borrower stranded. Islamic banks, on the other hand, are obliged to share in both the risks and the rewards. Because of this rule, the most used instruments of Shari’ah-compliant-funding are profit and loss sharing schemes called musharaka. In this arrangement, the financier takes some ownership, or equity, in the business, allowing it to benefit from a share of profits made. However, any losses are also shared in proportion to each partner’s invested capital.

Do I have to be Muslim to use Islamic finance?

No. Providing the finance is used for a permitted activity, anyone can use Islamic finance products and services – you don’t have to be Muslim.

Andrea Reynolds
Swoop’s CEO & Co-Founder

A word from Andrea

"With shared profit and loss loans, zero interest charges, and a commitment to supporting non-harmful enterprises, Islamic finance is quickly becoming a major force in Nigerian business lending. Under the terms of Shari`ah law, Islamic institutions do not charge interest on Shari`ah-compliant loans or pay interest to customers who deposit money into a current or savings account with an Islamic bank."

What is the meaning of Sukuk?

A sukuk is an Islamic financial certificate, (similar to a bond in Western finance), that complies with Shari’ah law. Sukuk demands the investor has ownership of real assets (such as a shipment of oil) and earns a return from those assets, (the sale of the oil). This is different from conventional bonds where the investor has a debt instrument earning a return via the payment of interest (riba) – which is forbidden by Shari’ah law.

What is meant by Murabaha?

A murabaha agreement is a form of Islamic finance contract in which an asset is sold for cost, plus profit. It is considered both halal (permitted) and Shari’ah-compliant.

A basic murabaha agreement gives the small business owner the resources they need to develop their business. These resources are assets they can put to work in the business, such as plant and machinery or inventory. Under a murabaha transaction, the financial institution is not permitted to charge interest on the funds they provide. Instead, the provider simply purchases an asset of the business and then sells the asset back to the business owner, along with a single additional charge. This single fixed fee is pre-agreed between both lender and borrower.

If a small business defaults on repayments, late payment charges are allowed. However, the financial institution must distribute the amount of any late payment charges received — after deduction of its actual costs — to any charitable foundations that may be selected at the discretion of the Shari’ah Supervisory Board.

What is Ijarah?

Ijarah is a lending arrangement often used for the purchase of business equipment, property, or other hard business assets. Ijarah permits the financial institution to earn a profit by charging leasing rentals to the borrower instead of lending money and earning interest.

Is Islamic banking interest free?

Yes. Charging interest on loaned funds is prohibited by Shari’ah. However, this does not mean business loans from Islamic lenders are cost-free. The institution will earn a profit on the loan by acting as agent or partner in the deal. (See the definitions of musharakah, murabaha, and ijarah above for more details).

How do I apply?

Understanding the complexities of Islamic finance can be challenging, especially for business owners not fully conversant with Shari’ah law. Contact Swoop today to learn more about the types of funding that may be available to you. Let Islamic finance give your business the boost it deserves.

Apply now.

Written by

Chris Godfrey

Chris is a freelance copywriter and content creator. He has been active in the marketing, advertising, and publishing industries for more than twenty-five years. Writing for Barclays Bank, Metro Bank, Wells Fargo, ABN Amro, Quidco, Legal and General, Inshur Zego, AIG, Met Life, State Farm, Direct Line, insurers and pension funds, his words have appeared online and in print to inform, entertain and explain the complex world of consumer and business finance and insurance.

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