Diving the Issue of Loan Application in Islamic Banking

Islamic banking operates on the principles of Shariah law, which prohibits the payment or receipt of interest and requires that all financial transactions be based on risk-sharing and ethical investment. As such, the concept of collateral security is dealt with differently in Islamic banking compared to conventional banking.

In Islamic banking, collateral security is often replaced by the concept of collateral-free financing or asset-based financing. Instead of requiring collateral, Islamic banks use alternative forms of security, such as mortgage of assets, assignment of receivables or guarantees from third-party providers. These alternative forms of security are considered more in line with Shariah law principles as they involve tangible assets and do not involve the payment or receipt of interest.

One example of collateral-free financing in Islamic banking is the concept of Mudarabah. In a Mudarabah contract, the bank provides the capital while the customer provides the labor and expertise. Profits are shared between the two parties based on a pre-agreed ratio while losses are borne by the bank alone. In this case, the customer's expertise and labor serve as the collateral, instead of requiring tangible assets as collateral.

Another example is the concept of Ijarah, which is a form of leasing. In an Ijarah contract, the bank purchases an asset and leases it to the customer for a pre-agreed period. At the end of the lease period, the customer can choose to purchase the asset at a predetermined price. In this case, the asset serves as collateral for the bank, instead of requiring the customer to provide additional collateral.

Overall, the concept of collateral security is dealt with differently in Islamic banking compared to conventional banking. Collateral-free financing and asset-based financing are often used as alternatives to traditional collateral security, as they are considered more in line with Shariah law principles.

 The Qard or Qard Hassan (Interest Free Loan)

Qard could be defined as an interest-free loan for needy borrowers extended on a goodwill basis; in particular Qard al Hassan provides funds for humanitarian and welfare purposes without any profit accruing to the lender. Therefore, qarḍ is a contract involving a loan with two parties on the basis of social welfare.

Qard is only applied when one gets obliged to return the equivalent of the money taken and repayment is for the same amount as the amount lent. Qard should not bring any return or addition to the lender because that would be equivalent to taking Riba. However, a borrower can pay more than the amount borrowed, but it must not be discussed in the contract.

In addition, in all credit transactions, Islam recommends witnesses and documentation (Quran 2:282). The conventional banking loan disburse priority is put on collateral security however Islamic Banking consider and make a check list of aspects like individual/organizational character, capital, cashflow, capacity and collateral (5Cs). Collateral is the last resort of Islamic Banking. Therefore these are measures that provides safeguards against disputes and allows credit transactions for a fixed or known time period. And since Islamic banks can neither pay interest nor charge any return on loans, where necessary, they have the right to ask for collateral to ensure recovery of the loan amount. Also, The Shariah puts a great deal of emphasis on repayment of loans/debts and the borrower also has a moral obligation to repay a loan. For that reason, banks can include, with mutual consent of the clients, a penalty clause in the credit contract to mitigate the risk of deliberate default in a form of mark up. For example in case the bank found out that the borrower is hiding from repayment of the loan and the bank suffers additional cost of transport, announcements, airtime and among others for the bank to discover the whereabout of the borrower. Such costs can be added to the principle amount to form the mark up price.

Summary of Loan acquisition/application: Normally the borrowing relationship between Islamic banks and their customer is "Buyer - Seller" relationship. This is realized in the example as follows; If party A (Customer/borrower) identifies a property and wishes to buy it. eg, Motor vehicle from Spear Motors (party B/seller), the Bank buys and owns it and then sells it to the customer (borrower). Later the borrower starts repaying the loan in accordance to the contract let say from salary account. However this is a different case to the conventional banks where the relationship is "Lender - Borrower". This means that in later case, the lender (conventional bank) pay out loan directly to the borrower (customer) especially after presentation of the collateral security as a priority. On top of repaying the same principle amount, with Islamic bank loan you're likely to buy the actual product.

For queries or supplements; 

Ssonko Muhammedi

PhD Candidate

Islamic Banking and Finance

UniSHAMS- University, Malaysia

Email (ssonko65@gmail.com)

Tel: +256754656089

Comments

  1. semwogerereJune 11, 2023 at 5:56 AM

    Assalam Alaikum Dr. Ssonko M.

    I have enjoyed reading your article on the concept of collateral security in Islamic Banking System. In my opinion, you have clearly highlighted the concept to the fullest. By providing the examples of Mudarabah and Ijarah help drive home your point that indeed, collateral-free financing and Asset-based financing are the gists of Islamic Banking System.

    Well done and thank you for sharing your research.





    ReplyDelete

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