Islamic Banking vs. Conventional Banking - Research Paper Example

 ISLAMIC BANKS V CONVENTIONAL BANKS Introduction When almost all the industries have severely been hit by the worst economic turmoil of the recent years, it was very interesting to note that Islamic banking and financing industry remained far positive despite the economic recession and it was, as many Islamic banks claimed, experiencing greater pace of its development (Oxford Business Group, 2008, p. 86). This has brought significant attention from many business giants, corporate and personal customers to Islamic banking. There has been growing trend towards Islamic banking as many customers, including both Muslims and Non-Muslims, in many countries embraced Islamic bank and its financial services. This piece of research paper attempts to address major differences between Islamic banking and conventional banking, mainly in relation to both of its underlying principles, theories, current practices and organizational systems. As widely known, Islamic banks requires strict compliance with Islamic Shariah, mainly based on its fundamental principle of ‘prohibition of riba-interest-‘ whereas interest plays significant roles in making conventional banks competitive in the market. Differences between Islamic banks and Conventional banks Islamic banks normally provide almost all services that conventional banks used to offer to its customers except that Islamic banks don’t accept or pay interests on lending and deposits and indulge with haram (Prohibited in Shariah) businesses or unethical business practices. The major functions of a commercial bank includes safeguarding customers’ money, supplying money, lending functions, investment function and other financing services. Islamic banks also provide all these services and moreover. Both Islamic banks and conventional banks provide various financial services like accepting deposits, lending functions, investments, trade-finance, accepting payments etc with a basic difference that any of these functions shouldn’t be anyway related to accepting or paying interest. Mani differences between the principles, practices and theories of Islamic bank with that of conventional banks are detailed below: 1- Interest for profit/ interest-forbidden Conventional banks generate profits from interests. They accept interest on most of its lending like overdraft and loans. People deposits money in banks, either for safeguarding or interest-earning purposes, which in turn allow the banks to use their money to deposit in other banks, like reserve banks, and generate interest thereon. This enables banks to pay relatively small rate of interest to their depositors (Houghton, 2009, p. 12), for instance 9% for fixed deposits and 3.5% for saving accounts. The conventional banks charge relatively high rate of interest on loans, overdraft and other lending. This is how conventional banks make money for their operation and for their profit need. Rewey (2005) listed basic three ways of how conventional banks make profits: 1- They make money from spread, which means the difference between the interest rate they pay to their customers and the interest rate they receive on loans and lending. 2- they earn interest on the securities they hold, and 3- they earn fees for customer services like checking accounts, loan servicing etc. (p. 74). Out of these three ways, the main two are closely related to interest. It is unusual to find a transaction which is interest-free in the case of conventional banks. When it comes to Islamic banks, the first and foremost principle of its operation is prohibition of interest- riba. One of the very basic tenets of Islamic financing and banking is that ‘riba is unjust and therefore it is haram’- prohibited (Hassan and Lewis,2007, p. 43). Islamic banking is a system of Shariah-based financing that primarily requires strict compliance with Shariah rules and principles. Islamic Shariah strictly prohibits accepting and paying of interest. Today, the Arabic word riba and its meaning are widely known, due to the emerging of large number of Islamic banking in more than 42 countries and many a number of people becoming its customers. Islamic banks, theoretically and in practice, avoids transactions that relate with accepting or paying of interests. For instance, it deals with variety of financial services like Mudarabah, Musharakah, Murabaha and Waidah, but, they are fully interest-free. All these services are somehow similar to the functions of commercial services expect that there is no interest element in any of these services. 2- Element of ‘Haram’ and ‘Halal’ The fundamental principles of Islamic banking are 1) prohibition of riba, 2) Prohibition of Gharar- dubious contracts and 3) prohibition of Maysir- gambling (Samad, Gardner and Cook, p. 72). As Sarker noted, Islamic banks are requires to strictly to avoid transactions and financial services that relate to accepting or paying of interest, dubious businesses and gambling or speculative businesses (p. 3). These three principles show the moral and ethical element in Islamic banking. Islam, as a religion, suggests not to exploit others money, not to deal with dubious businesses and gambling etc. Islamic banks thus require adherence to not only to Shariah principles but also to the moral and ethical perspectives of Islamic Shariah. Conventional banks do not require compliance with any other dogma and therefore there is no ‘haram’ element. Riba, Gharar and Maysir are haram in Islamic banking whereas they are allowed in conventional banks. Conventional banks are free to accept interests, pay interests to its customers, provide services to any business regardless of dubious, immoral, gambling, speculative, casino etc. Islamic banks are required to ensure that it participates only in Halal activities due to that Shariah has forbidden involving in activities and business that relate alcohol, pork-based products, tobacco, cinema, pornography etc. In contrast, there is no religious or social or legal restrictions on conventional banks in dealing with these sorts of activities. 3- Compliance Shariah compliance is necessary for an Islamic bank whereas conventional banks require no compliance with any religion. It makes Islamic banks more responsible than conventional banks. Islamic banks are required to ensure Shariah-compliance in all of its operations including services in provides to the customers, internal control of the organization, managerial activities, accounts preparation and financial reporting etc. Sole (2007) stressed that Islamic finance is based on the principles established by the Shariah and other jurisprudence or rulings called fatwa. It has become a common practice that Islamic banks assign supervisory boards and other responsible people to ensure compliance to Shariah (p. 4). As Schoon (2009) emphasized, Shariah compliance can be achieved only when Islamic banks avoids riba, gharar and Maysir and when these are satisfied, the bank requires to obtain Shariah Supervisory Board’s approval to market the products and services. But, conventional banks are allowed to market its products and services through various channels like window, branch, subsidiary etc (p. 53- 54). 4- The principle of profit and loss sharing The financial instruments like Mudharabah and Musharakah are based on the principle of profit and loss sharing. The Mudarabah (profit and loss sharing) and Musharakah (joint venture) contended that Islamic banks should provide its financial services to the borrowers on a risk sharing basis, in contrary to the interest-based financing in which the borrower assumes all risks to take (Saeed, 1996, p. 51).. Both Mudarabah and Musharakah impose greater risks on Islamic banks. The profit and loss sharing mode of Islamic financing raises several important considerations, mainly it may increase the overall degree of the risk of the asset side of bank’s balance sheet. The profit and loss sharing principle of Islamic banks make them more vulnerable to risks that are normally borne by equity investors rather than debt holders (Sundararajan and Errico, 2002, p. 4). As Mudarabha and Musharakah impose greater risks on Islamic banks, many Islamic banks have recently kept Profit equalization Reserve, which is that part of amounts appropriated out of the gross income of Mudarabah before allocating the share of Mudarib (bank), to ensure smooth return to be paid to the invest account holders. Profit equalization reserve helps Islamic bank create a hedge against the future low-income distributions by keeping a portion of the current available profits to pay out to the investment account holders (Hassan and Lewis, 2007, p. 443). Though conventional banks also follow profit and loss sharing principle, it has aligned with interest and therefore the risk associated with it is relatively smaller. Conventional banks thus do not require keeping a profit equalization reserve. Mudharabah- main features Islamic banks provide necessary capital funds to the business people to start or expand the business It is an agreement in which Islamic bank finances for the project and the entrepreneur is entitled to carry out the business, Islamic bank will have significant concern on the business and its performance, because business failure will be a big loss for the bank, and therefore, Islamic bank will carefully analyze the business project, possibility of success in its market, market threat and opportunities, competition rivalry etc in order to come to a decision whether to be financed or not. Business man or entrepreneur is responsible to provide skills, workforce, management and other necessary arrangements for the running of the business The profit made out of this business contract is to be shared among the bank and business man based on a pre-determined profit sharing ratio, If the business experiences loss, bank faces losses of the capital provided and the business man faces loss of labors, management and any other efforts that are being used by him. Mudharabah arrangement helps create and encourage mobilization of funds to the business sectors. Musharakah Main Features it is a contractual relationship between two parties, both parties should contribute capital to the business, profit will be shared among them based on a pre-fixed ratio and loss shall be shared among them based on equity participation. Musharakah is a Sharia Contract in which one party (Islamic bank) agrees to contribute capital to the business in an agreement to share the profit and loss. Profit is shared on an agreed ratio and the loss is divided according to the equity participation ratio. It is very similar to present day joint venture arrangement. 5- Supervisory requirements Islamic banks require Shariah Supervision and there is must be a Shariah supervisory board in an Islamic bank, being responsible to ensure Shariah compliance. The Shariah Supervisory Board must comprise of people who are experts, skillful and knowledgeable in Shariah jurisprudence, current banking trends and practices and are able to explore Quran, Sunna and Fiqh in order to issue relevant fatwas in times of requirements (Timm, 2007, 42). Shariah supervisory board will be responsible to ensure Shariah compliance throughout all of its transactions, activities, managerial roles, accounting and auditing program etc. Conventional banks normally do not require an internal supervisory board and there is nod for ensuring compliance to any principles or rules. Differences between Islamic and conventional banks in respect to its functions and services 6- Safeguarding Customers’ money Both conventional and Islamic banks accept and safeguard customers’ money. Conventional banks offer various accounts like Current Account, Saving Account, Fixed Deposit Account and Time Deposit Account etc. Islamic banks generally offer three kinds of wadiah and Murabaha (Deposit) accounts current, savings and investment accounts. Features Both Islamic and conventional banks provide current accounts for business people, savings accounts mainly for low earning people and fixed or investment accounts for depositing fixed amounts for a fixed period of time, Both these banks provide any time deposits and any time withdrawals for both current and savings accounts, and Both these banks facilitate cheque, credit cards, debit cards and ATM for withdrawals and payments of cash Differences Conventional banks give high rate of interests on fixed deposit accounts and relatively smaller rate of interests on savings accounts, but Islamic banks don’t offer interests on any of deposit accounts, Conventional often charge for the service on current accounts only, but, Islamic banks charge for administering and clerical expenses and a service charge. 7- Lending functions Major lending functions are overdraft and loans. Conventional banks offer over draft as short term lending and charge high interests. They provide loans as long term lending and charge relatively (as compared to overdraft) less interest. Islamic banks also provide both loans and overdraft to the customers, but the main difference is that no interest is charged on any of its lending. Differences Conventional banks charge interests on all of its lending, but Islamic banks don’t charge any interests on its lending, Conventional banks may not charge for the services, but, Islamic banks charge or the service because that is the only way it can meet its expenses. Islamic banks do not provide loans and overdrafts for any speculative and other types of haram businesses. The loan facility offered by Islamic bank is called Qard, which legally means to give anything valuable in the ownership of the other by way of virtue so that the latter could avail of the same for his benefit with the condition that same or similar amount of that thing would be paid back on demand or at the settled time 8- Murabaha and Cost-Plus Murabaha is a cost-plus contract in which the seller (Islamic bank) mentions the cost of the goods or equipment or commodity that he has incurred and sells it to another party (buyer/ customer) by adding some profit or mark-up. The Murabaha system is also referred as Cost-plus arrangement. The Cost-plus arrangement is common pricing method in marketing and is prevalent in the conventional banking system except that conventional banks may add interest to the value of the goods or commodity. Murabaha is thus a sale of asset or commodity at the price the seller purchased it with an addition of certain amount of profit, which will be known to both the parties. Murabaha is a method of ‘financing resale of goods’. It does not belong to the profit and loss sharing agreement but it is a sale and purchases contract with a deferred payment element. The salient features of the Murabaha contract are detailed below: 1-The contract should be a valid contract and it must be free from riba 2- Islamic bank should disclose the actual cost incurred for purchasing the equipment, and depreciation amount can be deducted only if it is there, 3- Islamic bank can add only a reasonable amount of profit, which must be acceptable to the buyer as well. 4- If the equipment or commodity has any errors or faults, it must be communicated to the buyer. 5- Both parties should act in good faith so that each one should disclose only true information each other. 9- leasing or Ijaarah One of the very common financing methods that conventional banks provide to business and corporate customers is Leasing. Ijaarah of Islamic is very similar to the conventional capital lease whereby the lessor (one who leases/ bank) maintains legal ownership of the leased asset and the lessee is granted usufruct privileges. Usufruct right or usufruct privilege means the legal right to own or use a commodity or asset. Ijarah involves transfer of the ownership of the service for an agreed period of time for an agreed amount. In this contractual relationship, three basic elements are to be incorporated. These elements are 1) a valid contract between two parties, 2) Lessor who transfers the service and the Lessee who takes the service and pays for it and 3) the object of the Ijarah contract, including the rental amount and the service. Both Ijarah and conventional capital lease are similar in many aspects. The lessor maintains legal ownership of the leased assets and lessee is granted an usufruct privilege. Both Islamic Ijarah system and conventional capital leasing allow the lessee to opt for acquiring the leased assets by completing the rental payments or by entering in to new contracts. Economically, an Ijarah system works and operates like an amortizing or bullet repayment loan in many respects. Islamic Ijarah system does not involve interest but the conventional lease arrangement involves interest that the lessor may charge an additional amount of interest to be paid by the lessee. Conclusion This piece of research work has highlighted main functions and services of Islamic banks in comparison and contrast with that of conventional banks. the major principles and practices of both these banks are distinguished in this paper. The paper has highlighted main features of Islamic bank’s services like Mudarabah, Murabaha and Musharabkah and analyzed how these are different from the common services offered by conventional banks. 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