by Anne Kiunuhe
The concept of Islamic banking — a financial, banking and lending system in which interest is not chargeable, remains a mystery to many. A lot of people are often left wondering how Islamic banks are able to make a return.
Although still fairly new, Islamic banking appears to have caught root in Kenya and at least two fully fledged banks have been licensed to operate. Many other mainstream banks are opening Islamic banking windows.
Banks offering Islamic banking have however had to contend with many legal hurdles, particularly because the doctrines of Islamic finance and banking laws in Kenya are at a variance. Islamic finance is a system of banking consistent with Islamic law, also called Sharia. The basic principle behind the banking is ethical capitalism.
The operations of Islamic financial institutions are primarily based on a profit and loss sharing principle, as opposed to the interest charged by conventional banks. An Islamic bank does not charge interest, but rather participates in the yield resulting from the use of these funds.
The depositors also share in the profits of the bank according to a predetermined ratio. Sharia law — the bedrock of Islamic banking — emphasises on equitable contracts.
The restrictions under Sharia finance law are: the prohibition of payment or receipt of riba (interest), the prohibition of gharar (preventable uncertainty); the prohibition of maisir (gambling); and the prohibition of haram (forbidden) activities.
They have had to find innovative ways to make profits, under the watchful eye of Sharia. The biggest issue is the prohibition on charging or receiving interest. This affects the running of customer deposit accounts, mortgages, and all loans.
Islamic banks have come up with solutions such as replacing interest with a cost plus markup equation. Under customary banking, for instance, a customer wishing to purchase a Sh1million house financed by a bank would simply identify the house and enter into a sale agreement with the seller.
The customer would then negotiate with his bank for, for instance, a one year loan for a principal amount of Sh1 million at say an interest rate of 20 per cent and use the loan to pay for the house. The total amount repayable to the bank would be Sh1.2 million and this would include an interest element of Sh200,000.
However, under Islamic banking, the bank cannot charge interest. The transaction would therefore work as follows. The customer would identify the house and agree the purchase price of Sh1 million. The Islamic bank would then purchase the house for Sh1 million and resell it to the customer for Sh1.2 million.
The Islamic bank would then advance a loan of Sh1.2 million to the customer repayable in instalments to enable him to purchase the house from the bank.
There are many other Islamic finance products. These include Musharakah — a partnership agreement between a bank and a customer in which the parties invest jointly as partners and the customer then buys out the bank's share over a period of time using profits from the joint venture.
Important question
The all important question is whether Sharia law is recognised in Kenya and whether Islamic banking products are in conformity with Kenyan banking laws.
Although the Constitution provides that "the jurisdiction of a Kadhi's court shall extend to the determination of questions of Muslim law relating to personal status, marriage, divorce or inheritance in proceedings in which all the parties profess the Muslim religion", it is noteworthy that jurisdiction does not extend to contractual relations in the context of a banking relationship.
Kenyan law does not, therefore, recognise Islamic financing law as forming part of the body of Kenyan law. In order for Islamic banking transactions to be enforceable in Kenya the transactions must conform to applicable laws in Kenya.
The Banking Act and the Central Bank of Kenya Act regulate the country's banking industry. Section 12 of the Banking Act prohibits banks from engaging in wholesale or retail trade or purchasing or holding any land or any interest or right in land and restricts a bank's investment in other institutions. This prohibition greatly cripples operations of an Islamic bank.
In order to conduct such Islamic banking in Kenya therefore, a bank would need to obtain from the Central Bank exemptions from the provisions of the Banking Act prohibiting banks from engaging in trade or acquiring or holding land. It is understood that some banks have already obtained such exemptions from the Central Bank.
There are many other complexities attendant to Islamic banking.
For instance, Islamic products such as Murabaha in which the bank acquires the asset and then resells it to the customer exposes the transaction to double taxation such as a double payment of stamp duty.
Ijara transactions would also be subject to VAT. It is therefore important to consider the tax and accounting treatment payments under such products.
Aware of implications
Ijara transactions which in conventional terms are leasing arrangements may also be deemed to be hire purchase transactions, thereby bringing them within the ambit of the Hire Purchase Act (HPA).
The Act regulates all hire-purchase agreements where the purchase price does not exceed Sh4,000,000, other than a hire-purchase agreement in which the hirer is a body corporate.
An Islamic bank would require a hire purchase licence to offer such Ijara products. Banks in Islamic banking business must therefore be aware of the implications that the HPA would have on the conduct of their business.
A bank undertaking Murabaha transactions may also be deemed to be a seller of goods thereby bringing it within the ambit of the Sale of Goods Act. The Act places a number of obligations on a seller of goods.
Some of these obligations include an implied warranty that the relevant goods are of merchantable quality and fit for their purpose. As such, the bank should also consider the application of the Act and understand how to limit its exposure under the Act.
The hurdles that Sharia compliant banks are having to contend with are many and onerous. In light of the significant impact that Islamic banking is set to have on the financial sector in Kenya, it is time the Government considered the changes that need to be made to banking laws in order to accommodate Islamic banking.
