June 25, 2021

How do Islamic banks make money?

City: Addis AbabaBusiness

Islamic banks, known as Interest-Free Banks (IFB) in Ethiopia, are making inroads into new markets.

Avatar: Nigist Berta
By Nigist Berta

Nigist is a senior reporter and content creator at Addis Zeybe, who is experienced in journalism and who explores her passion for storytelling.

How do Islamic banks make money?

As regulators grow increasingly open to accommodating different financial models, Islamic banks – known as Interest-Free Banks (IFB) in Ethiopia – are making inroads into new markets.

Islamic banks make a profit through equity participation, which requires a borrower to give the bank a share in their profits rather than paying interest.

In 2019, the National Bank of Ethiopia gave the notice to allow the formation of fully-fledged Islamic banks to offer financial services that comply with Sharia Law. ZamZam Bank became the first bank to secure a license and commence operations. 

With more than 870 million Br and 1.8 billion Br in paid-up and subscribed capital, raised from 11,200 shareholders, ZamZam recently became operational as a pioneer of full-fledged, interest-free-bank in the country.

ZamZam started the establishment process almost a decade ago following a law that allows the formation of IFB. However, the process was halted after a new directive issued by the National Bank limiting IFB service as a window service, a special facility offered by conventional banks. Following this, over half of the 17 banks have started the service as window service.

However, those who want to form a full-fledged IFB saw a ray of hope following a speech by Prime Minister Abiy Ahmed at an Iftar program held two years ago at the Millenium hall. Abiy pledged to allow the formation of full-fledged IFB banks. ZamZam became the first to resume its establishment process. 

Two years down the line, ZamZam has finalized the establishment process and commenced service a few weeks ago. Hijra has also reached the final stage of commencing operations. Close to eight more banks are also in the process of formation. 

The way IFB operates is different from the conventional banking service. As its name indicates, it does not involve interest. When someone wants to start a business but doesn't have enough capital to build it, then the person can take a proposal to an Islamic bank and convince them to invest in the project. The bank then funds the business, whether in cash or through assets, while the borrower runs the enterprise. Then the borrower will split the profit of the business with the bank at a pre-agreed ratio, and if the business makes a loss, the bank loses its investment. 

“This is sort of a win-win situation,"  said Nasir Dano, organizer, and chairman of ZamZam bank’s board of directors. 

Islamic financial institutions generate profits through Mudarabaha, where an Islamic bank purchases an asset on behalf of a client, e.g. a car, and resells that asset to the client at a marked-up price. Usually, the client pays for the asset in installments.

“This differs from a conventional loan where the bank lends money to clients to buy the asset and charges them interest on the loan amount,” says Nasir. “With Murabaha, the bank finds the product, buys it, and resells it to the client with a markup.

Even if the system is relatively new to the country, it is gaining more users and advocates. Moonira Abdelmenan is a client of Islamic banks. She finds the scheme less financially risky and more resilient compared to conventional banks. For her Islamic banks are less likely to disintermediate during a financial crisis

Moonira, who frequently advocates Islamic banking on social media, told Addis Zeybe: "The efficiency and stability of Islamic banks compared with conventional banks merits further. So when I compare conventional and Islamic banks I have found that Islamic banks are less cost-efficient but have higher asset quality." 

Expansion to the world’s major financial markets pits Islamic banks against much bigger and established players, but the greater size also enables them to standardize products and bring costs down to a level where they can compete for head-on with conventional banks, according to industry experts. 

Ahbab Abdela, Hijra bank shareholders head, told Addis Zeybe that Islamic banks are for all people. "Islamic financing can serve everyone irrespective of religious beliefs, wealth, ethnicity, caste, or creed," he added.

Hijra Bank, Joined the market with 9,000 shareholders who have subscribed for 1.2 billion Br worth of shares, of which 650 million Br is paid.