CHAPTER TWO

LITERATURE REVIEW

2.0 INTRODUCTION

The effects of QH in the economy can be seen from macro- and micro

context. At macro level, Selim (2019) and Selim and Hassan (2020) study

QH as a tool of monetary policy (MP) and discuss the role of the central

bank. Selim (2019) argues that QH-based MP is more effective than

conventional MP due to following reasons: first, QH-based MP positively

influences real sectors of the economy. Second, it increases output and

helps an economy return to full employment. Third, QH help maintain

price stability by providing the lowest possible borrowing costs across the

economy. Finally, QH-based MP also improves current account balance

and foreign currency reserves with the Central Bank. In the micro context,

Islamic scholars and economists have contributed numerous intellectual

documents to provide various perspectives to poverty alleviation. Sadeq

(1997) provides a conducive poverty alleviation framework. His

framework has three broad categories of poverty alleviation measures.

First, the positive measures are expected to lead IMEFM to high level

income and its equitable distribution which include income growth,

functional distribution of income and equal opportunities to all. Second,

the preventive measures are expected to limit concentration of wealth,

which are control of ownership and prevention of malpractices in

economics and business that lead to income concentration. Third,

corrective measures are meant for correcting imbalances in the distribution

of income and wealth and to upgrade economic conditions of the worse-off

population in the society, which include compulsory transfer payments,

recommended transfer payments and state responsibility. If these measures

are applied, the problem of poverty could be solved quite substantially.

According to the Sadeq’s poverty alleviation framework, QH (interest-free

loan) can be treated as recommended transfer payments that falls under

corrective measures. Mannan (2017) provides a model of cash-waqf as a

new strategy for interest-free micro-credit (QH) to reduce human poverty.

He emphasizes on creating a World Social Bank that will contribute to

poverty alleviation through cash-waqf endowment to provide QH or

micro-credit at zero rate interest to the poor.

2.1 OVERVIEW OF INTEREST-FREE BANKING

2.1.1 Definition and Principles

Interest-free banking, also known as Islamic banking is a financial system

that operates in accordance with Islamic law (Shariah). It prohibits the

collection and payment of interest, and instead, focuses on profit-sharing

and risk-sharing between the bank and its customers.

2.1.2 History and Development

Interest-free banking has its roots in Islamic economics and finance, which

dates back to the 7th century. However, modern Islamic banking emerged

in the 1960s and 1970s in countries such as Egypt, Malaysia, and Pakistan.

However, the movement for interest free banking started in Pakistan in

1950’s according to Ali (2002), and soon spread to the Arab world with

the opening of the Mitrghamr Savings Bank in Egypt in 1963 which was

followed by the Nasser Social Bank. It means that practical Islamic

banking commenced from Africa. The task for the establishment of

interest free banking is legendary. At the dawn of Islamic banking

revolution in Republic of Iran, many foreign and local depositors withdrew

their money in the local banks to foreign-based banks and this action

exposed the local banks to possible failure. To arrest the failure of local

banks, the Republic of Iran on the 7th of June 1979 nationalized all the

local banks in the country to safeguard national rights and capital flight.
The interest free banking law promulgated in the Republic of Iran and

ratified by the Islamic Consultative Council on 1st September 1983, which

is part of the functions of Central Bank of the Islamic Republic of Iran.

Prior to the above development, as explained by Mannan (1980), in 1970,

Pakistan, Karachi and Egypt sponsored a proposal to establish an

international Islamic bank at the conference of foreign ministers held in

Karachi. Experts from more than fifteen Islamic countries examined the

proposal and recommended that interest based financial system should be

discarded and replaced with a system of profit and loss participation

scheme. As a result of the acceptance of the proposal with some

modifications, it was agreed that a Federation of Islamic Banks and an

International Islamic Bank be established.

2.1.3 Key Features

Interest-free banking is characterized by the absence of interest rates, the

use of Shariah-compliant financial instruments, and the emphasis on risk-

sharing and profit-sharing.

Moreover, features of non-interest banks as identified by Ogundina (2000)

and Oluyombo (2004) are listed below to include.

 i. Operation on the basis of profit and loss sharing and equity

participation

ii. Mobilization of savings through direct participation of savers and

entrepreneurs

iii. Co-operation in all deals because one who “shares the profit must

share losses in the same proportion”.

iv. Combination of investment and development activities to bridge

the gap between the rich and the poor.

v. Extension of bank activities beyond economic to social and

cultural upliftment of the people

2.2 HISTORY AND FRAMEWORK OF NIGERIAN ISLAMIC

BANKING SYSTEM

Efforts to provide Islamic banking services in Nigeria date back to the

early 1960s. A certain bank in Lagos by name Muslim Bank West Africa

Limited was reported to have attempted to provide Islamic financial

services to interested customers in 1961. Three cases involving the Islamic

Bank of West Africa, Lagos were reported in the Supreme Court of

Nigeria between 1933 to 1975: United Nigeria Insurance Co Limited v.

Muslim Bank (West Africa) Limited [1967 – 1975] (Liability of bank to

drawer), United Nigeria Insurance Co Limited v. Muslim Bank (West

Africa) Limited [1967 – 1975] (Duty of Bank) and Nigeria Breweries

Limited v. Muslim Bank (West Africa) Limited [1933 – 1966] The

foregoing legal cases involving the Muslim bank have shown that Islamic

banking efforts in Nigeria started in the 1960s.

The propagation of Islamic banking in Nigeria started gaining ground in

the 1980s. Some University based Islamic centers and Islamic groups

launched sensitisation campaigns through conferences and seminars in

most parts of the North and South West of the country with a view to

creating awareness among Nigerians, particularly Muslims, on the evils of

interest/usury based banking and the need for adopting Islamic banking on

the one hand, and on other hand, making the Government see reason why

Muslims should be given the opportunity to conduct their financial

activities in line with the provisions of the Sharī’ah.

The Banks and Other Financial Institutions Decree which was enacted in

1991 was the first piece of legislation that served as a gateway to Islamic

banking in Nigeria. Two provisions in the Decree, Section 39(1) and

Section 23(1) provided the first singular effort by the Government of

Nigeria to recognise Islamic banking and provide the foundation for the

establishment of Profit and Loss Sharing (PLS) banks in the country.

Based on the provisions of the two sections, two banks were said to have
been licensed in 1992 to carryout banking business using PLS modes but

none was able to commence operation. In 1996, the defunct Habib Bank

Nigeria Plc opened a non-interest banking window but could not also

record significant success due to absence of framework for non-interest

banking in the country. In 2004, the Central Bank of Nigeria (CBN)

granted Jaiz Bank approval in principle to operate as a full-fledged Islamic

bank. However, due to an upward review of minimum capital requirement

from N2 billion to N25 billion for deposit money banks in July of the same

year, Jaiz could not commence operation immediately.257 Following the

Central Bank of Nigeria’s (CBN) reclassification of banks into

international, national and regional in 2010, a framework for the regulation

and supervision of Non-Interest Financial Institutions (NIFIs) was released

in 2011. According to the Framework, a NIFI is defined as: (i) full-fledged

Islamic bank or full-fledged Islamic banking subsidiary of a conventional

bank; (ii) full-fledged Islamic merchant or full-fledged Islamic banking

subsidiary of a conventional merchant bank; (iii) full-fledged Islamic

microfinance bank; (iv) Islamic branch or window of a conventional bank;

(v) Islamic subsidiary, branch or window of a nonbank financial

institution; (vi) a development bank regulated by the CBN offering Islamic

financial services; (vii) a primary mortgage institution licensed by the

CBN to offer Islamic financial services, either full-fledged or as a

subsidiary; and (viii) a finance company licensed by the CBN to provide

financial services, either fullfledged or as a subsidiary. According to the

guidelines, interest-based banks, whether commercial or merchant, and

other financial institutions operating in Nigeria may offer or sell Sharī’ah-

compliant products and services through subsidiaries, windows or

branches only.

Jaiz bank succeeded in obtaining a license to operate as a non-interest

regional bank in November 2011 after satisfying the new capital

requirement of the apex bank. The bank commenced operation in January

2012. Jaiz was upgraded to a national bank in 2016 following the license it

obtained from CBN to offer Islamic banking services across the country.

In 2019, a new bank, TAJ Bank was licensed to operate as a full-fledged

non-interest regional bank and in July 2022, the bank secured CBN’s

approval for nationwide banking operations. A third non-interest bank,

Lotus Bank was also licensed in 2021 to operate as a full-fledged regional

bank.
2.3 CONCEPT OF INTEREST-FREE BANKING

Interest-free banking operates on the principle of profit-sharing, where

financial institutions earn returns through investments in ethical and

tangible assets. Key features of interest-free banking include:

• Murabaha (Cost-plus Financing): Banks sell goods at a cost-plus-

profit price. Murābaha is derived from ribh, which means gain, profit or

addition.276 It is defined as a particular kind of sale where the seller

expressly mentions the (total) cost of the sold commodity he has incurred,

and sells it to another person by adding some profit or mark-up

thereon.277 A distinguishing feature of Murābaha from other kinds of sale

is the disclosure of cost price. If a person sells a commodity for a lump

sum price without any reference to the cost, the sale is called Musāwamah

(bargaining).

• Mudarabah (Profit-sharing): Partnerships between banks and clients,

where profits are shared, but losses are borne by the bank. Mudārabah is a

profit-sharing and loss-bearing contract where one party supplies funding

as capital owner (rabbul māl) and the other provides effort and

management expertise as manager (mudārib) with a view to generating a

profit. The ratio in which the total profits of the enterprise are distributed
between the capital-owner and the manager of the enterprise is determined

and mutually agreed at the time of entering into the contract, before the

beginning of the project. In the event of loss, the capital owner bears all

the loss and the principal is reduced by the amount of the loss. It is the risk

of loss that entitles the capital-owner to a share in the profits. The manager

bears no financial loss (unless it results from negligence on his/her part),

having lost his time and his work efforts.

• Musharakah (Joint Venture): Both bank and client share profits and

losses. Mushārakah is a profit-and-loss sharing partnership. It is a contract

of joint partnership where two or more partners provide capital to finance

a project or own real estate or movable assets, either on a permanent or

diminishing basis. Partners in Mushārakah have a right to take part in

management; they seem to bear the greatest risk among all Islamic

financing modes with the potential for earning the highest reward.

However, whereas profits are distributed according to pre-agreed ratios,

losses are shared in proportion to capital contribution.

2.4 IMPACT OF INTEREST-FREE BANKING ON PUBLIC

EMPOWERMENT

• Access to Credit: Interest-free banks typically offer more accessible loan

terms, making it easier for low-income individuals and small businesses to

obtain financing without the burden of interest. This leads to increased

financial inclusion.

• Social Welfare: By providing financial services that do not impose high-

interest rates, interest-free banking can alleviate poverty, promote

entrepreneurship, and reduce inequalities.

• Entrepreneurial Growth: With affordable financing, individuals can start

businesses, creating job opportunities and boosting local economies.

CONCEPTS OF ISLAMIC BANKING AND FINANCE

1. Shariah Compliance: Islamic banking and finance operate in accordance

with Shariah principles, which prohibit the collection and payment of

interest, speculation, and uncertainty.

2. *Financial Instruments*: Islamic banking and finance use a range of

financial instruments, including mudarabah (profit-sharing), musharakah

(partnership), and ijara (leasing).

3. *Risk Management*: Islamic banking and finance emphasize the

importance of risk management, which is achieved through the use of

Shariah-compliant financial instruments and the sharing of risks between

the bank and its customers.

2.5 THEORETICAL FRAMEWORK OF INTEREST-FREE

BANKING

1. *Islamic Economics*: Islamic economics provides the theoretical

framework for interest-free banking, emphasizing the importance of

fairness, justice, and social welfare.

2. *Agency Theory*: Agency theory is used to explain the relationship

between the bank and its customers, emphasizing the importance of trust,

transparency, and accountability.

3. *Stakeholder Theory*: Stakeholder theory is used to explain the

importance of considering the interests of all stakeholders, including

customers, employees, and the wider community.

2.6 REVIEW OF EMPIRICAL STUDIES ON INTEREST-FREE

BANKING
1. Financial Performance: Empirical studies have shown that interest-

free banking can be financially viable and sustainable, with some studies

suggesting that Islamic banks outperform conventional banks in terms of

financial performance.

2. Social Impact: Empirical studies have also shown that interest-free

banking can have a positive social impact, particularly in terms of

financial inclusion and poverty reduction.

3. Challenges and Limitations: However, empirical studies have also

highlighted the challenges and limitations of interest-free banking,

including the lack of standardization and regulation, and the need for

greater awareness and education.

2.7 GAP IN EXISTING LITERATURE

1. Limited Research on Interest-Free Banking: Despite the growing

importance of interest-free banking, there is still a limited amount of

research on this topic, particularly in terms of its impact on public

empowerment.

2. Lack of Standardization and Regulation: There is a need for greater

standardization and regulation of interest-free banking practices, which

can help to promote transparency, accountability, and trust.

3. Need for Greater Awareness and Education: There is a need for

greater awareness and education about interest-free banking, particularly

among policymakers, regulators, and the general public.

2.9 CHALLENGES OF INTEREST-FREE BANKING

SYSTENIGERIA: Theoretical discussion

Aliyu (2010) observed that there are many challenges that confront interest

free banking (Islamic) banking in secular environments. These problems

have been discussed earlier by several scholars such as Siddiqui (1983),

Gusau (1986), Aliyu (1988), Malami (1992), Adebayo (2010), Adegbite

(2011) etc. Some of these challenges are presented as follows:

a) Inadequate Legal and Regulatory Environment

Malami (1992) observed that the existing banking laws in many so

called secular countries like Nigeria which are mainly applicable to the

interest based conventional banks constitute the most serious challenge to

the operation of interest free banking. He opined that Islamic banking

operations in Nigeria will largely be inhibited by a number of banking

laws and regulatory directives such as companies Act, Banking Act, and

Central Bank 0rdinances. For instance the banking laws prevented the

Daral- Ma’al- al- Islami (D.M.I) from establishing an Islamic bank in

Nigeria in 1980. The D.M.I insisted on owning fifty one percent of the

bank‟s shares, while the indigenization of banking laws did not allow

more than 40% foreign ownership. Similarly, Adebayo (2010) observed

that the 2004 CBN bank consolidation policy which increased the

capitalization of commercial banks from 2 billion to 25 billion constituted

a potential bottleneck in the take-off of full-fledged interest free (Islamic)

bank like JAIZ bank as well as the smooth running of Islamic windows in

conventional banks. Therefore, he (2010) suggests that legal and

regulatory bottlenecks have to be removed to avoid operational conflict by

making necessary amendment to the Nigeria banking laws and regulations

to accommodate the peculiarities of the IFB system. Alternatively, the IFB

could be exempted from certain regulations associated with interest

dealings.

b) Manpower Problem

There is problem of shortage of professionally qualified personnel

to operate interest free banks in Nigeria (Abubakar, 2001). In fact it has

been widely acknowledged that there is a global shortage of experienced

professionals in Islamic finance sector to feed the industry and the

regulators. This no doubt would be a glaring challenge for Nigeria. In

addition, there is still the challenge of having qualified and competent

Shariah scholars with good grounding in Islamic finance and

jurisprudence. This would be a critical issue since most of the instruments

and services would have to be cleared by each firms Shariah board.

Therefore, Malami (1992) points out that there is the need for staff

development in Shariah, economics and accounting based on Islamic

principle in order to overcome such challenge.

c) Problem of Competition

In the face of increasing financial globalization: Interest free banks

are confronted with the challenges of stiff competition with the present

conventional interest based banks, who are well established. Interest free

banks as new entrance may found it different to compete favourably with

the existing big and strong banks in the short run. Mirakhor (1995)

observes that perhaps the most challenging issue facing the

implementation of an Islamic financial system is the development of risk

bearing instruments that can provide the investor with sufficient degree of

liquidity, security and profitability to encourage their holdings. Islamic

banks therefore, face the challenge of developing innovative services and

products for mobilizing deposits and utilizing them effectively for

financing under profit and loss sharing system. Islamic banks like all other

banks under the interest based system have to remain competitive and
tailor their services and products according to the needs and requirements

of their clients simultaneous to ensure that the product designed by them

remain within the framework of Shariah.

d) Religious Misconceptions

The fact that Nigeria is a multi-religious and multicultural society

presents a big challenge to the interest free banking system which is

essentially based on Islamic principles. Experience shows that religion has

been a very volatile issue in Nigeria. In particular, interest free banking in

the country is being perceived by Christians as a process of Islamising the

nation (Aliyu, 2010). Gusau and Bawa (1983), Malami (1992), Bashir

(2010) Adegbite (2011), Sanusi (2011) and others observed that the

Christian opposition against the establishment of Islamic bank is due to

lack of understanding of the objective of the bank. Malami (1992) further

argued that there has been Christian opposition to the Muslims in Nigeria

such as the anti-Shariah debate, in which the Christians calls for the

removal of Shariah from the Nigerian constitution during the 1978

constitution assembly, opposition to Nigeria‟s membership to

Organization of Islamic Countries (OIC) in 1987, criticism against the

Shagari administration for the provision of funds for the building of

National Mosque and Church at the Federal Capital Territory, Abuja.

Thereafter, there has been wide anti-Shariah struggles which started in

Kaduna since the year 2000 after the reintroduction of Shariah in some

Northern states between 2000 and 2002. Therefore, this unfortunate

culture of Islamaphobia arising from misconception and misunderstanding

may limit the patronage of interest free (Islamic) banking window.

However, Adebayo (2010) contends that mass awareness can help correct

some misgivings and misinterpretation about interest free banking in

Nigeria.

e) Moral Harzard

The tendency of corruption and unethical practices by Nigerians had

been identified as one of the challenges that can negatively impede the

success of the interest free banks just like their conventional counterparts.

Interest free banks are morally driven since they are based on ethical

values such as truthfulness, justice, and fear of God. Aliyu (2010) stated

that IFB could be negatively affected by fraudulent practices from clients.

This is an issue which involves immorality such as concealment of truth in

declaration of the quantum of profits by clients and loan defaults. Some

clients may also approach Islamic banks for Qard Hasana loan with the

aim of default. These problems can be reduced by moral training and

effective management, auditing and supervision.

f) Poor Financial Literacy

In Nigeria, a large proportion of cash is being held by the non-bank

public, particularly the informal sector due to low level of financial

literacy (Adgbite, 2011). Thus, Interest-Free Banks are faced with the task

of simultaneously contributing in raising the level of financial literacy as

well as showing the viability of interest free services to attract customers

(Adebayo, 2010). Other challenges of interest free banking in Nigeria

identify by Gusau (2000) and Adebayo (2010) includes: Problem of excess

liquidity. Absence of accounting and auditing standards, lack of Shariah

compatible investment outlets or short term money market instrument to

invest excess liquidity of Islamic banks, absence of Islamic insurance and

capital market institutions to protect investments of interest free banks

against unforeseen hazard and facilitate the growth of the industry

respectively.