Islamic Banking vs Normal Banking Differences and Similarities - Essay Example

Islamic banking vs. normal banking – differences and similarities Islamic banking vs. normal banking – differences and similarities Introduction The rules and structure of banks worldwide are based on similar criteria aiming to secure the integration in the global market. Since, under the influence of culture and ethics is it possible for unique modes of financial institutions to appear: the case of Islamic banking is an indicative example. Initially, this type of banking has been related to the needs of people living in particular regions. Gradually, Islamic banking was expanded worldwide addressing people in the Western markets. Current paper explores the similarities and differences between Islamic banking and conventional banking in order to show whether both types of banking can be equally developed in the international market. Despite the fact that many similarities have been identified between Islamic banking and conventional banking their differences are many. This means that before promoting Islamic banking in a particular market it would be necessary to check the cultural, social and economic characteristics of that market in order to estimate whether Islamic banking could survive in the above market or not. Islamic banking vs. normal banking – similarities In order for a financial institution to be considered as a bank there are certain requirements that need to be met (Aldohni 2012). At this point Islamic banking has, necessarily, certain similarities to conventional banking. Primarily, Islamic banks, as normal banks, have the potential to accept ‘the deposit of money’ (Aldohni 2012, p.64). In addition, both Islamic banks and normal banks offer to their customers the option of current account (Aldohni 2012). This type of account has been set by international bodies but also by the courts as a prerequisite in order to characterize a financial institution as a bank (Aldohni 2012). In general, Islamic banks have all functions that can be met in conventional banks (Gannon 2009). Still, these functions are organized differently in Islamic banks, compared to conventional banks, at the level that Islamic banks are based not only on common law but also on the principles of shari’a (Gannon 2009). The compatibility between Islamic banking and conventional banking is proved through the following fact: many conventional banks have developed a division based on the rules of Islamic banking, aiming to attract the customers who are interested in the financial products of Islamic banking (Gannon 2009). Still, these products are often not fully aligned with the rules of Islamic finance, as in Islamic banks, i.e. in banks that are based solely on Islamic finance (Gannon 2009). Islamic banking vs. normal banking – differences The lack of any interest in the transactions developed in Islamic banks is a ciritical difference between Islamic banking and conventional banking (Gannon 2009). Since there is no interest in transactions Islamic banks can secure their profitability by using the ‘Profit and Loss structure (PLS) accounts’ (Gannon 2009, p.36), i.e. a scheme that ensures the sharing of profits and losses between the customer and the bank. Through this scheme Islamic banks can significantly reduce their losses, a fact that allows these banks to secure high net profits (Gannon 2009). The PLS scheme is considered as one of the most important features of Islamic banking; using this feature Islamic banks can respond to ‘the financing needs of their customers’ (Gannon 2009, p.37) without having to face the risks of ‘lending money’ (Gannon 2009, p.37), as these risks are common in conventional banks. In general, Islamic banks can be considered as non-common banking institutions since their activities are more similar to investment and not to pure banking, as appear in conventional banks (Gannon 2009). In practice it has been proved though that the profits achieved by Islamic banks using the PLS are rather low, compared to the profits that conventional banks can achieve through their financial products (Umar & Ahmad 2010). The key advantage of PLS, as a scheme, seems to be its potential to protect the bank from excessive loss and not to secure for the bank high profit (Umar & Ahmad 2010). The characteristics of PLS, as a scheme, reflects the different approaches used by Islamic banks and conventional banks in regard to the achievement of profit; for conventional banks profit should be a priority while for Islamic banks profit should be considered as the result of a fair negotiation/ agreement between the customer and the bank (Umar & Ahmad 2010). In Islamic banking fairness in negotiating with the customer means that the customer’s interests are addressed at the same level with the interests of the bank (Umar & Ahmad 2010). The use of PLS in Islamic banks has been related to the following principle of Islamic banking: in all transactions developed in the context of Islamic banking emphasis should be given to the relationship with customer (Ariff & Iqbal 2011). Indeed, through PLS the customer has to pay the bank only if ‘profit was achieved’ (Ariff & Iqbal 2011, p.80). In conventional banking any amount given to the customer as a loan needs to be paid back in full, along with relevant interest, no matter of the existence of profit for the customer or not (Ariff & Iqbal 2011). In other words, in Islamic banking the role of the bank is closer to that of the mediator in an investment, but with the benefit of loss-sharing (Ariff & Iqbal 2011). At the next level, Islamic banks provide to their customers the option of a current account, a scheme though that it is mandatory for a business that aims to be characterized as a bank (Aldohni 2012). Still, in Islamic banking current accounts do not incorporate ‘an overdraft facility’ (Aldohni 2012, p.66), as such facility is prohibited in the context of Riba, one of the rules of Islamic banking. On the other hand because the above facility is crucial for most customers, Islamic banks in western countries have introduced modes of current accounts that incorporate overdraft schemes; the latter are appropriately structured so that they are not opposed to the rules of Islamic banking (Aldohni 2012). In any case, in current accounts also, as in all transactions developed in Islamic banks, no interest is set (Aldohni 2012). In conventional banks interest is an important element of all transactions, always in accordance with the local laws related to banking activities (Aldohni 2012). It should be noted though that current accounts, as part of Islamic banks, are differentiated from the current accounts available in conventional banks: in islamic banks the current accounts have the form of ‘interest free loans, also known as qard hassan’ (Hassan & Lewis 2007, p.144); these loans need to be repaid by a particular date, as noted in the agreement signed between the customer and the bank. In conventional banks the customer is able to deposit money in his current account but without strict terms, as of the level of the payment made each time, the time point of the payment or the date of return of the full amount (Hassan & Lewis 2007). Of course, different terms can be included in the current accounts of a conventional bank, as these terms will be incorporated in the relevant agreement with the customer (Hassan & Lewis 2007). An important difference between Islamic banks and conventional banks is their exposure to risks. Islamic banks are likely to face two types of risks: those risks that are normally incorporated in banking activities, meaning the risks also faced by conventional banks, and the risks related to the principles of Islamic banking, as these principles are influenced by shari’a (Hassan & Lewis 2007). The above fact is made clearer if referring to the investment options available in Islamic banks: in all these banks deposits are based on the rule of ‘profit-sharing’ (Hassan & Lewis 2007, p.144); this practice is aligned with the rule of ‘mudaraba’ which allows to Islamic banks the introduction of deposit accounts that offer different investment options but which are all based on the term of ‘profit-sharing’ (Hassan & Lewis 2007, p.144). In conventional banks profits, in the form of interest, are available only to customer; the latter can agree to the sharing of these profits with the bank but such agreement is not an indispensable part of deposits in conventional banks (Hassan & Lewis 2007). In the Islamic banking if the customer fails ‘to return the full amount with the specific date’ (Hassan & Lewis 2007, p.145) this failure is considered as a credit risk. At this point, Islamic banking can be considered as similar to conventional banking. Still, in regard to other forms of credit risks Islamic banks are different from conventional banks. For example, when the customer of an Islamic bank fails to provide to the bank the profit arranged in the context of a ‘profit sharing agreement, such as mudaraba and musharaka’ (Hassan & Lewis 2007, p.145) the bank is able to use any tool provided by the law for receiving its profit. The above risk is also considered as a mode of credit risk in the context of Islamic banking (Hassan & Lewis 2007). In conventional banking the profit promised by the customer to the bank is usually retained by the bank at the moment when the profit is achieved, without the customer to be able to prohibit the access of the bank to his investment account (Hassan & Lewis 2007). In Islamic banking where the customer is given the power to control fully its investment having the responsibility to inform the bank for any profit achieved the case of credit risk in the form of losing the profit achieved by an investment, as explained above, is quite common (Hassan & Lewis 2007). In general, in Islamic banking profits, as also losses, are ‘shared between the customer and the bank’ (Gannon 2009, p.36); this fact offers to the customers of Islamic banks the chances for high profits, under the terms that their investment is appropriately managed so that losses are kept low. In conventional banks customers do not participate in the loss; this means that conventional banks are higher exposed to market risks compared to Islamic banks (Gannon 2009). However, this risk is potentially controlled in the case of conventional banks due to their practice in regard to profits: in conventional banking customers participate in profits only at a fixed rate, i.e. interest, as arranged between them and the customer in advance (Gannon 2009). This means that if profit is higher than initially expected the customer cannot seek for the increase of its share, unless a different term has been set in his agreement with the bank (Gannon 2009). Due to their rules and to the structure of their products Islamic banks are able to offer to their customers quite high stability while in conventional banking stability is quite difficult to be secured (Gannon 2009). Another important characteristic of the financial products available in Islamic banks is their variety: the financial products of Islamic banks are usually more than those available in conventional banking, a fact that is considered as a significant benefit for the customers of Islamic banks (Ariff & Iqbal 2011). Moreover, since debt in Islamic banking need to be ‘backed by goods and services’ (Ariff & Iqbal 2011, p.82) the potentials of Islamic banking to enhance the performance of an economy are significantly more than those of conventional banking. Indeed, in Islamic banking the provision of funds to the customers is based on the following term: those funds will be used for covering the purchase of specific goods/ services (Ariff & Iqbal 2011). This means that in Islamic banking customers have necessarily to buy specific goods/ services in order to seek for funding (Ariff & Iqbal 2011). This practice creates a direct link between banking and the local market (Ariff & Iqbal 2011). Conclusion Islamic banking has many differences from conventional banking, as analyzed above. In fact, the similarities between the two types of banking are limited to those terms that are mandatory for a business in order to be characterized as a bank. In this context the following question would appear: is Islamic banking, as a business framework, appropriate for the international market? The answer would be positive but under the following term: that the rules of financial markets worldwide would be alternated; more emphasis should be given on ethics and on customers’ needs than on business profit. In their current form Islamic banks would be able to enter western markets around the world but only if they would be willing to increase their flexibility. This means that certain of the rules of Islamic banking would become more aligned with the rules of conventional banking. For example, no chance would exist for Islamic banks to expand their activities in the western countries if they would not lower their lending policies: in current market the potential of a bank to cover the borrowing needs of its customers, individuals or businesses, is considered as of primary criterion for the bank’s popularity. In other words, Islamic banking would not be able to secure access to all markets unless it would be able to increase its exposure to risk, either in the short or the long term. References Aldohni, A. (2012) The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at the United Kingdom and Malaysia. London: Routledge. Ariff, M. & Iqbal, M. (2011) The Foundations of Islamic Banking: Theory, Practice and Education. Cheltenham: Edward Elgar Publishing. Gannon, P. (2009) Business Knowledge It in Islamic Finance. London: Essvale Corporation Limited. Hassan, K. & Lewis. M. (2007) Handbook of Islamic Banking. Cheltenham: Edward Elgar Publishing. Umar, A. & Ahmad, F. (2010) Developments in Islamic Banking Practice: The Experience of Bangladesh. Boca Raton: Universal-Publishers Read More