This study will try and identify the differences between the Islamic and conventional banking from earlier days as well as today. While looking at the differences the study will identify the advantages and disadvantages for both sides equally. It will also talk about finances for both banking systems.
This study is going to look at all the sources available such as: books, journals, newspapers, previous studies and internet.
What is Islamic banking?
Islamic banking is a new way of financial intermediation and investment management that has emerged and gained a sizeable share of the market in its home base, the Persian Gulf countries. Islamic banking has popularized itself in Malaysia, Indonesia and the Americas, and a number of Muslim countries have adopted the new system at the state level (Asutay, 2013) Healy Consultants believes that Islamic banking brings forth many advantages and thus provides Islamic banking services. Below are listed the advantages and disadvantages of Islamic banking (Healy Consultants Pte Ltd 2003)
- Islamic banking is becoming very popular amongst international investors. Having committed itself to a text accessible to all and Prophetic precedents available easily, Islamic banking is open to any innovations that are in congruence with its fundamentals. It is not a closed system. It has no regional, ethnic or class affiliations.
- In Islamic banking, only one kind of loan and that is qard-el-hassan (literally good loan) whereby the lender does not charge any interest or additional amount over the money lent.
- In Wadiah (safekeeping), a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it.(Zamir Iqbal and Abbas Mirakhor 2007:106)
- Islamic banking is more efficient in that it allocates investable funds on the basis of the expected value productivity of projects rather than on the criterion of the creditworthiness of those who own the projects, which is the case in debt-based finance.
- Islamic banking is less prone to inflation and less vulnerable to speculations, which are currently being fueled by the presence of huge quantities of debt instruments in the market.
- Islam encourages people to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. As defined in the Shari'ah, or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, farms, service companies or simple trade deals.
- Investments should only support practices or products that are not forbidden or considered unlawful, or haraam, by Islamic law. Trade in alcohol, for example would not be financed by an Islamic bank; a real-estate loan could not be made for the construction of a casino; and the bank could not lend money to other banks at interest.
- Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else (Hadzic 2005:77).
All over Europe Islamic banks are establishing branches, Western banks are offering Shar’ia-compliant financial services, and European governments are trying to out-compete each other in welcoming them. Proponents of banking along the lines of Sharia’a (Islamic law) claim that the Islamic banking system is “more ethical” than the West’s capitalist system. This is not true. Unfortunately, however, in our age of crashing financial markets, many Westerners – not just the traditional anti-capitalist European left – seem very eager to buy that argument.(Fikret Hadzic 2005:78)
Advantages of European conventional banking
- Transaction costs will be eliminated
- Price transparency
- Uncertainty caused by Exchange rate fluctuations eliminated
- Single currency in single market makes sense
- Rival to the 'Big Two' - Japanese Yen and The US dollar (Fikret Hadzic 2005:80)
- Increased Trade and reduced costs to firms
- The instability of the system
- Over estimation of Trade benefits
- Loss of Sovereignty
- Deflationary tendencies
More about Islamic Banking
After its first introduction on experimental basis in a small town of Egypt in 1963 many Islamic Banks, both with letter and spirit, were established in the Middle Eastern and Asian regions. The growth of Islamic banking has been increasing ever since, not only in terms of number of countries it is operating in but also in term of areas of finance it has ventured in. In three decades, Islamic banks have grown in number as well as in size worldwide and are being practiced on even more intensive scale (Jahangiri 2009:21).
Some countries like Sudan and Iran, have converted their entire banking system to Islamic Banking. In other countries where conventional banking is still dominating the Islamic Banking is operating alongside. Today, Islamic banks are operating in more than sixty countries.
Islamic Banking and Finance is growing at between 10% and 15% per annum and is boasting global assets in excess of $1Trillion. A recent survey indicated that there are more than 160 Islamic financial institutions existing worldwide. (Hadzic, 2005: 18)
Gradual and steady spread of the Islamic banks over time over the world is a lucid manifestation of success and the symbolic growth rate is the hallmark of this emerging market. Being fastest growing segment of the credit market in Muslim countries, market share of Islamic banks in Muslim countries has risen from 2% in the late 1970s to about 15 percent today (Asutay, 2013).
Islamic banking is getting popularity, warm welcome, and appreciation also by non-Muslims in Muslim and non-Muslim countries. Although, most of the Islamic banks are within Middle Eastern and/or Emerging countries, many universal banks in developed countries have started to spigot huge demand of Islamic financial products (Moin, 2008)
This also confirms that Islamic banking is as viable and efficient as the conventional banking is. Where the financial liberalization and deregulation have created new challenges and new realities for Islamic banks, the globalization effect has also put these institutions in cutthroat competition with traditional financial institutions in well developed financial markets.
It has become indispensable for Islamic banks to be innovative in designing Islamically acceptable instruments to grapple with the unremitting innovations in financial markets and to compete in local and global deposit markets. Moreover, for fund mobilization and utilization, Islamic banks must seek investment opportunities and avenues that offer competitive rates of return at acceptable degrees of risk. In order to maximize the value of the bank, management of the bank should carefully consider interactions between different performance measures.
Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Shari’ah or Islamic law. It is also referred to the types of investments that are permissible under this form of law. A unique form of socially responsible investment, Islam makes no division between the spiritual and the secular, hence its reach into the domain of financial matters.
Islamic Banking and Finance defined
Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shari’ah. Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking, the more general term is expected not only to avoid interest based transactions, prohibited in the Islamic Shari’ah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.(Al-Gamal, 2007)
Islamic banking is the system of banking consistent with principles of Islamic law (Shari’ah) and guided by Islamic economics. Islamic economics is referred to that body of knowledge which helps realize human well-being through an allocation and distribution of scarce resources that is in conformity with Islamic teachings without unduly curbing individual freedom or creating continued macroeconomic and ecological imbalances.
A key element of Islamic economics is distribution of equitable rewards to the different factors of production. Islamic economic system seeks system of Redistributive justice where concentration of wealth in a few hands is countered and flow of money into the economy is fluent (Bank Alfalah limited 2006-2007)
Islamic banking is, therefore, seen as a lynchpin to achieving the economic and social goals of the Islamic economic system. As system of Islamic banking is grounded in Islamic principles and all the undertakings of the banks follow Islamic morals so it could be said that financial transactions within Islamic banking are a culturally-distinct form of ethical investing. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of Usury, the collection and payment of interest, also commonly called Riba in Islamic discourse. Although collecting and paying interest is not permitted under Islamic law, revenue-sharing arrangements are generally permitted.(Ataul 2005:10)
One must refrain from making a direct comparison between Islamic banking and conventional banking (apple to apple comparison). This is because they are extremely different in many ways. The key difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations with as of the conventional.
The foundation of Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the Shariah in all of its actions and deeds. The original meaning of the Arabic word Shariah is 'the way to the source of life' and is now used to refer to legal system in keeping with the code of behavior, called for by the Holly Qur'an (Quran). Amongst the governing principles of an Islamic bank are:
- The absence of interest-based (riba) transactions
- The avoidance of economic activities involving oppression (zulm)
- The avoidance of economic activities involving speculation (gharar)
- The introduction of an Islamic tax,( zakat)
- The discouragement of the production of goods and services which contradict the Islamic value (haram)
On the other hand, conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.
Islamic law considers a loan to be given or taken, free of charge, to meet any contingency. Thus in Islamic Banking, the creditor should not take advantage of the borrower. When money is lent out on the basis of interest, more often it leads to some kind of injustice. The first Islamic principle underlying for such kind of transactions is 'deal not unjustly, and you shall not be dealt with unjustly' (Suratul-Bakarah 2:279) which explain why commercial banking in an Islamic framework is not based on the debtor-creditor relationship.
The other principle pertaining to financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk.
Thus, financial intermediation in an Islamic framework has been developed on the basis of the above-mentioned principles. Consequently, financial relationships in Islam have been participatory in nature (Al-Gamal, 2007).
Even though the direct comparison could not be made between the two the differences can still be seen. This study has singled some differences below (Al-Gamal, 2007).
The odd numbers refer to Conventional Banking and even numbers refer to Islamic Banking:
- The functions and operating modes of conventional banks are based on fully manmade principles.
- The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.
- The investor is assured of a predetermined rate of interest.
- In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
- It aims at maximizing profit without any restriction.
- It also aims at maximizing profit but subject to Shariah restrictions.
- It does not deal with Zakat.
- In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre and they also pay out their Zakat.
- Lending money and getting it back with compounding interest is the fundamental function of the conventional banks.
- Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customer's business very well.
- It can charge additional money (penalty and compounded interest) in case of defaulters.
- The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are given for early settlement at the Bank's discretion.
- Very often it results in the bank's own interest becoming prominent. It makes no effort to ensure growth with equity.
- It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.
- For interest-based commercial banks, borrowing from the money market is relatively easier.
- For the Islamic banks, it must be based on a Shariah approved underlying transaction.
- Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations.
- Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.
- The conventional banks give greater emphasis on credit-worthiness of the clients.
- The Islamic banks, on the other hand, give greater emphasis on the viability of the projects.
- The status of a conventional bank, in relation to its clients, is that of creditor and debtors.
- The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller.
- A conventional bank has to guarantee all its deposits.
- Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss Position.
This study shows us that there are similarities as well as differences between the Islamic and conventional banking. Islamic finance as defined in the Shari’ah or Islamic law is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, farms, service companies or simple trade deals. In other words these should be helping each other no matter what the circumstances are.
When looking deeper into this study the differences become crystal clear. For example in the Islamic banking there are not any doubts, but as the study takes a look at the conventional banking it is a different story. For instance there is the instability of the system which would for example not suit the UK at all.
Throughout most of the 1980s the UK refused to join the ERM (Exchange rate mechanism). It argued that it would be impossible to maintain exchange rate stability within ERM, especially in the early 1980s when the pound was a petro-currency and when the UK inflation rate was consistently above that of Germany (Hadzic, 2005:66). This forms a competition between them.
Over estimation of Trade benefits differentiates the two banking systems as well. Some economists argue that the trade and cost advantages of Economic and Monetary Union (EMU) have been grossly overestimated. There is little to be gained from moving the present system which has SOME stability built into it, to the rigidities which EMU would bring.
Loss of Sovereignty is yet another issue which moves the two types of banking into different directions. On the political side, it is undemocratic. Governments must be able to control the actions of the central banks because governments have been democratically elected by the people, whereas an independent central bank would be controlled by a non elected body.
It seems like that the Islamic bank is always there for a customer and a conventional bank is not. Conventional banking takes the majority of the profit but shares the losses with its customers, which is a total opposite from what the Islamic banking is trying to achieve. One is better off with the Islamic banking from whichever aspect of business we look at it.
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