Main Differences between Islamic and Conventional Bank - Case Study Example

Islamic Banking and Finance Main differences between Islamic and conventional bank Comparison between Islamic and conventional banking can not be made like apple to apple comparison. The two are extremely different the key difference being Islamic banking is based on the foundation of Shariah. Sharia law is the basis through which business approach, transaction, responsibility product features, investment focus and all dealings are made (Samad 5). Islamic banking is based on Islamic economics principles, in accordance with the Islamic Law (Sharia). These principles are caliphate and assuming the political framework is non-Islamic. Caliphate is the form of Islamic government which represents leadership of the Muslim world and political unity. Assuming the political framework is non-Islamic is a principle which integrates prominent Islamic doctrines into an economic framework that is secular (Al-Omar & Abed-Haq 21). Conventional banking is based on a principle that the more you have is the more you get and if you got nothing then you get nothing. The main difference between Islamic banking and conventional banking is that money according to the teachings of Islam has no intrinsic value and people are not supposed to profit from lending it out. Interest (riba) cannot be charged. There is prohibition of making money out money and wealth is only accepted if it is generated through investment and trade that is legitimate. In case of any gain resulting from trading, it should be shared between the expertise provider and the capital provider. This means if profit is made as a result of trading the profit is shared between the bank and its customers at an agreed ratio. But for someone to share profits with the bank, he or she must hold a savings or investment account with the bank (Zaman & Movassaghi 32) Conventional banking practices aim is to eliminate risks while Islamic banking is aimed at bearing risks in any transaction involved. Conventional banks don’t take the liability when involved in a transaction with a consumer and only get benefits from the consumer in form of the interest charged. Islamic banking when involved in a transaction with any consumer, thy bear all the liability and it is declared Haram if the bank benefit without bearing its liability. The Islamic banking foundation is based on the Islamic faith and its deeds and actions must stay within the limits of Shariah. Among the principles governing Islamic banks are the absence of Riba (interest based transactions), avoiding oppression (zulm) involving economic activities, avoiding any trading activities that involve speculation (gharar), introduction of tax (zarat) and discouragement of goods and services production which contract the value of Islam (haram) (Al-Omar & Abed-Haq 23). Conventional banking is based on the relationship of debtor-creditor which is between the bank and the depositor and the bank and the borrowers. The price of credit considered is the interest charged and reflects the opportunity cost of money. In conventional banking besides being a store of value and a medium of exchange, money is a product, whereas in Islamic banking money is just but a medium of exchange and real asset is the product. The basis for charging interest on capital in conventional banking is time value whereas the basis for earning profit in Islamic banking is the profit on exchange of goods and services. In case an organization suffers loss in conventional banking still interest in charging and thus no loss sharing. In Islamic banking losses are shared when the organization runs at a loss. While distributing working capital finance, cash finance and running finance in conventional banking, there is no exchange of goods and services agreement made while in Islamic banking, under Murabaha, Istisna and Salam contracts, there must an agreement executed for the exchange of goods and services (Samad 10). In conventional banking inflation is created when expansion of money takes place due to goods and services that are not in existence behind the money while distributing funds. There is always existence of goods and services in Islamic banking where expansion of money doesn’t take place. Conventional banking cause inflation which then triggers the entrepreneurs to increase prices of goods and services while there is no extra rice charged by the entrepreneur due to the control of inflation in Islamic convention. In conventional banking loan from the central bank through money market operations can easily be obtained by the government without capital expenditure initiation. In Islamic banking, the government must deliver goods to the National Investment fund before obtaining loans from the monetary agency. Islamic banking is based on the foundation of Islamic principles under the Sharia law. The convention banking is based on the principle of the more you have the more you get. The main difference between Islamic banking and conventional banking is that unlike conventional banking, Islamic banks don’t charge interest and profits are shared between the banks and its customers. The main types of financial product used by Islamic banks and how the key features and techniques of these products (such as Mudaraba, Murabha and Musharaka....etc) differ from those offered by interest orientated Western banks There are Islamic financial products which are accessible to customers and include treasury deposits, insurance (Takaful), term deposits, equities ( Sukuk) and mutual funds. Term deposit n a financial institution is a deposit or savings for a fixed period of time when a customer may withdraw the money after a fixed term is over. In a conventional banking the customer earns interest on the investments made. However the term deposit is different for the Islamic banks since earning of interests is not allowed. In Islamic banks a mutual fund is a group of financial instruments like stocks, bonds and certificates of deposit where a professional manages the pooling of money by investors in the purchase of stocks and bonds. Though other conventional banks promise a certain interest rate on the same, Islamic banks don’t earn interest for their customers but share profits. Takaful, an Islamic insurance allows the participants to contribute to the insurance fund collectively and gain collective beneficial rights (Donsyah 5). The contribution is invested and surplus distributed and participant’s claims paid out of the collective account. There are techniques used by Islamic banks to provide its products. These techniques are Mudaraba, Murabha, Musharaka, Istisn’a and Bai Muajjal. Murabaha has a literal meaning of a sale on mutually agreed profit. It is a contract of sale where in which the seller declares his cost and profit (Hassan & Mervyn 96). This is a mode of financing in which Islamic banks have adopted. A client requests the bank to purchase certain goods on his behalf which the bank does for a profit over the cost. A relationship established by parties for sharing profits and losses in the joint business under the parties’ mutual consent is known as the Musharrakah. The Islamic bank provides as agreement mixed with the business enterprise and other funds. Capital provides can participate in management but not necessarily. The profit earned is distributed among the partners according to the agreed ratios and the loss is distributed according to each partner’s respective capital contribution. A special kind of partnership where a partner gives partner money to invest in a commercial enterprise is called Mudarabah. Rabb-ul-mal is the first partner whose investment comes while mudarib is the other person whose work and management is exclusively his responsibility. Mudarabah means profit sharing and is a contract in which one hundred percent capital is provided by one party while the other provides knowledge and expertise to invest and manage the investment projects. When profits are generated, they are shared according to the agreed ratio. Only the money lender takes losses. A contract in which there is payment for goods to be delivered at a later date is made in advance. The seller will supply specific goods to the buyer at a future date in exchange of fully paid amount in advance at the contract time. There is no dispute arising due to ambiguity as the intended quality of community to be purchases is fully specified. The objects of the sale should not be currencies, silver or gold but goods. It covers quality, quantity and workmanship. Bai Muajjal is a credit sale and is a financial technique that takes the form of Murabaha . The bank after purchasing goods allows the buyer to pay for the goods at a stated date in full or in installments and earns a profit margin on that purchase. The cost of the product and profit margin is mutually agreed. The fixed price for the commodity can be the same, higher or lower than the spot price. Istisna’s is a contractual agreement for goods and commodities manufacturing and allows cash payment in advance and delivery of goods in future or future payment and future delivery of goods. It can be sued for providing financial facilities in contraction of highways, building of bridges, projects, houses and so on. Musawamah is a kind of sale which in which the commodity price that is to be trades is bargained between the seller and the buyer without referring to the price paid or incurred cost by the former seller. Musawamah seller is not obliged to reveal the cost he is incurred like in Murabaha but the parties negotiate on the price. When the seller is not n a position to ascertain precisely the costs of commodities that is offered to sell, Musawamah is used instead. Islamic financial products are treasury deposits, insurance (Takaful), term deposits, equities ( Sukuk) and mutual funds. Term deposit n a financial institution is a deposit or savings for a fixed. The financial products techniques used are Mudarabah, Murabaha, Musharaka, Istisn’a and Bai Muajjal. Analysis of the performance of Islamic banks compared to conventional banks. (Soundness, Prudence, Effectiveness, Economy, and Profitability). Islamic banks outperform the conventional banks in almost all areas and years as they usually show better results than conventional banks. Fairly satisfactory results of key ratios were yielded when Islamic banks were evaluated. The performance of Islamic banks can be analyzed in its soundness, prudence, effectiveness, cost efficiency and profitability. The ability of a bank to meet its responsibility in a situation of crisis is soundness of that bank and is measured according to the capital-assets ratio. Capital-ratio monitoring is very important to a bank because there is a minimum amount of the bank’s capital that is required by the regulatory authority. The size of the bank will also determine if it can satisfy its responsibility towards its creditors. Capital amount also affect the bank’s equity holders rate of return. In Islamic banks there is always trade offs between the owners return and the bank’s safety (Mohamed 35). When there is return on assets, the smaller the capital of the bank is the higher the owners of the bank will gain on the rate of return. Lower capital-asset rations increase the bank failures’ risks and the reason why a certain minimum capital-asset ratios are prescribed the regulatory agencies. Islamic banks are therefore more conservative as compared to western banks. They have less access to funding of wholesale for enabling rapid growth of loans. Islamic banks have been faring on well on the credit crisis better than the western banks. When it comes to prudence or liquidity, banks are require legally to keep a certain amount of their deposits in a liquid form to avoid crisis of confidence and failure caused by the inability of banks to provide their depositors on demand amount to withdraw on their deposits. Prudence requires a balancing act that is very delicate between liquidity and profitability as they are divergent objectives. The current ratio measures the bank’s ability to meet its current liabilities which are the demand deposits. Islamic banks are believed to have excess liquidity. There are no possibilities of Islamic banks borrowing from the Central Bank in case of a need due to the interest involved and that is why they need to be more liquid. In Murabahah form of financing, a customer requests an Islamic bank to buy a certain product for him. The customer then buys the product from the bank at an agreed profit basis which is not really different to conventional banks’ interest charged (Tarawneh, 109). This mode of financing is less risky because it is short term and thus enables Islamic banks to maintain high liquidity to cover for their short term financing, making it more liquid than the conventional banks. Effectiveness is seen in how a bank uses its resources. The score of Islamic banks is calculated as Deployment Ratio = Total Investment (+Financing)/Total Equity + Total Deposits. The investment of Islamic banks is quite high for its majority of banks as compared to conventional banks. On economy or cost efficiency, it is one of criteria for banks’ performance evaluation. The standard indicator is ‘cost to income’. Poor cost performance is over 70% while good cost performance is less than 60%. Islamic top bank average is 62% as a benchmark. Conventional banks have lower cost ratios than Islamic banks. The profitability of a bank is the net after-tax income or net earnings of that bank usually divided by the bank size measure. The rate of return on assets (ROA) and the rate of return on equity (ROE) are the ratios used to measure the profitability of banks (lson & Zoubi 45). Well capitalized banks face lower external financing costs which reduce their costs and thus enhancement of profits (Pratomo & Ismail). Islamic banks are know to be well capitalized and stable and are likely to yield profits just like conventional banks. A study taken showed that there is difference between profitability of Islamic banks and conventional banks (Samad 22). This can be explained by the fact that Islamic banks obtained revenues from its financing activities which steadily increases. The analysis of the performance of Islamic banks compared to conventional banks is based on the soundness, prudence, economy and profitability of those banks. Islamic banks are well capitalized, stable and capitalized. They also make use of the resources at their disposal very effectively despite the absence of interest rates. Conventional banks’ depositors are guaranteed principal amounts, bearing fewer risks as compared to the depositors of Islamic banks. To compensate for the extra risk, the depositors of Islamic bank would expect higher rate of returns which might not be the case. Works Cited Al-Omar, Fuad & Abdel-Haq, Mohammed . Islamic Banking: Theory, Practice, and Challenges. Zed Books, 1996 Ariff, Mohamed. Islamic banking in Southeast Asia: Islam and the economic development of Southeast Asia. Institute of Southeast Asian Studies, 1988 Hassan, Kabir & Lewis, Mervyn. Handbook of Islamic banking. Edward Elgar Publishing, 2007 Kuncara, Ari & Rochmah, Siti. “The Interest Prohibition and Financial Performance of Islamic Banks: Indonesian Evidence”. International Business Research, 1.3 (2008). Melaty, Ghazali. The Bank Specific and Macroeconomic Determinants of Islamic Bank Profitability: Some International Evidence. University of Malaya, 2008 Mohamad, Shamsher , Hassan, Taufiq & Khaled, Mohamed . 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