Disadvantage and Disadvantage of Islamic Banking and Conventional Banking - Case Study Example

Islamic Banking Name Institution Date Islamic Financing Musharakah Musharakah is considered as one type of Shirkat-ul-Amwal which in the generally means sharing. In terms of business it is a joint enterprise whereby the parties share the profits and losses. It plays an essential role in terms of providing an alternative for the interest based economy. According to the basic rules of Musharakah, it is a contract and all the terms and conditions of the contract have to be met. The proportions of the profits have to be determined at the time of contract. It is recommended in most cases that the partners should share the profits equally in accordance with the initial investment (Ariff & Iqbal, 2011). This means that the ratio of profit distribution may be varied. The share of losses is also equal to the initial distribution of investment. The nature of capital is not restricted and the partners with non-cash contributions are allowed. In-kind contributions are not allowed as it may need to be liquidated and distributed. In terms of the management, the partners may act as an agent for the partnership although they are free to make any alternative arrangement for the management of the partnership. Musharakah can be terminated if one of the partners dies, one of the partners becomes insane or one of the partners terminates the partnership. However, the partnership may still continue if the other partners are still interested in the partnership but they have to develop a mutual agreement. During the preparation of the contract, the partners can agree on the rules regarding the termination of the partnership. Murabahah The concepts of murabahah initially involved the exchange of transaction where the buyer purchases the goods at a profit that is specified by the seller and payable to the seller. The seller has to set reasonable profits that are agreeable to both parties. The whole concept is based on the trust between both parties as the buyer has to trust that the profit that has been set is the true cost. The concept of Islam is considered in the case of Murabahah as it is forbidden to rent out money. The concept of Murabahah is mainly used for the purposes of facilitating the short-term trade transaction (El-Gamal, 2011). In the current situation, the Islamic banks have replaced the traditional traders who were involved in the process as the sellers. It is also referred to as cost plus financing since it utilizes the concepts of trade finance based upon the letters of credit. Most of the modern Islamic financial markets base their activities on the concepts of Murabahah. However, Murabahah is surrounded by a controversy in terms of the price for spot payment and the price for deferred payment. When dealing with the Murabahah concept, the end user has to settle the outstanding amount in one lump sum upon delivery. The settlement has to be made at a specified date with the financier maintaining ownership of the purchased item until delivery is made. The mark-up to be applied has to be agreed upon by the end user and the financier. Under the arrangement, the seller may require the buyer to provide security for payment. Sukuk Sukuk is commonly considered as the Islamic equivalent for bonds. However, Sukuk mainly grants the investors the share of assets together with consummate cash flow and risk. As a result of this, Sukuk adheres to the Islamic laws which are commonly referred to as the Shariah principles which outlaws charging or payment of interest. The concept of Sukuk is considered as one of the most important development in the Islamic Capital Markets. Sukuk also plays an important role in terms of acting as a bridge between the issuers and the investors. High levels of transparency are usually in place when using the concepts of Sukuk and it has won the support of most investors in the Islamic Capitals market. Shariah Boards of Islamic Scholars is responsible for approving the structures developed by the foreign and domestic investors. The issuarance of Sukuk has increased from US$ 14.9 billion in 2008 to US$ 23.3 billion in 2009 (Saoumare, 2012). The market has a huge potential for growth due to the support that it has gained in the market. The main concept that governs Sukuk involves the partial ownership of debt, assets, project, business and investment. The certificates of debt are not tradable when using the concept of Sukuk. Under the Islamic Shariah laws, the certificate of debt can only be bought before the finance takes place and held till maturity. Money is considered as a tool for measuring the value and it is not considered as an asset. Ijarah Ijarah mainly utilizes the concepts of a lease which allows one party to the property of another party for a specific period of time for an agreed upon price. It therefore allows a party to use the assets of another party for their own benefits without the requirement of ownership. The parties involved can agree on the terms of use through developing rules to govern the process. In order for an ijarah to be valid, the parties must be known and specified in a way that eliminates the potential of any dispute. Any item that is difficult to derive the benefits of its use cannot be subjected to Ijara. According to the concepts of Ijara, it is forbidden to involve any unlawful substances or activities when using the property (Beck, et al, 2013). Before a party is allowed to use the property, an agreement must be made in advance with regards to the payment and the lease period. The lease period must be clearly specified and the lessor maintains ownership of the property throughout the lease period. Any liabilities that are incurred in the case of using the property are usually incurred by the lessee. The lessee is also liable for any loss to the assent which is due to acts of negligence. However, the lessee cannot be held liable for the loss of the property in case it is as a result of natural causes. Mutual consent is important between the contracting parties when the concepts of Ijarah are used. The contracting parties can also make stipulations to avoid any form of delayed payment. Disadvantage of Islamic Banking and Conventional banking Islamic banking The Islamic banking poses risks to the depositors due to the profit and loss sharing models. The depositors have limited scope in terms of managing the bank. The voting measures against the management are low for the depositors and this increases their risks. The Islamic banking is too complicated and expensive and hence increasing the costs to the depositors. This can be attributed to the strict laws and regulations that have to be followed. Each of the transactions carried out in the Islamic banking requires more than one contract and the banks have to deal with the delivery issues which is not part of their business and hence increasing the costs (Hanif, 2014). The required guarantees also make it difficult for some of the clients to utilize the services of the bank. The possibility of hedging and diversification of the risk is very limited in the Islamic Banking. This is because derivatives, forwards and future are banned by the shariah laws which govern the operations of the banks. The Islamic banks cannot invest in risky projects that may end up with higher returns. This is attributed to the Shariah laws which prohibit such practices. The Islamic Banking faces principal agent problem as principal instruments used is the Shariah law and vetting is done by the Islamic boards. The Islamic boards are usually appointed by the banks which creates a conflict of interest. The lack of qualified scholars impacts negatively on the professionalism of the processes being carried out. The Shariah Standards lacks conformity which creates inconsistencies in the interpretation and implementation of the Shariah laws. The Islamic banks have to pay high amounts to the Islamic Scholars which also affects the growth and development of the banks. The financial ratios in the Islamic banks are quite high due to the lack of supply and inadequate financing (Ryu, et al, 2012). This is considering that the Islamic Financial Institutions require a lot of secondary market for the financial instruments. A lot of tax barriers are in place when dealing with the Islamic banking. This can be attributed to the double contracts on the assets. In some instances, the Islamic financial institutions lack authenticity. The Islamic banks are mainly centered on short term financing and it also takes a long period of time for the profits to be generated. This is attributed to the strict Shariah laws that govern the institutions. Conventional banking Although the conventional banking has been in place for a long period of time, it has some disadvantages. The conventional banking is prone to a lot of instability due to difficulties in maintaining the exchange rates. This affects the operations of the conventional banking and it may also end up affecting the customers. The conventional banking also expensive and charges are usually applied when it comes to most of the services. Almost all transactions are charged and hence making it expensive. The conventional banking relies on the charging interests and fees on services. This exposes the customers to a lot of risks in case of economic fluctuations. The interest rates may be increased and hence impacting negatively on the customers. The banks in the conventional industry may also collapse in the event of economic recession due to the reliance on the interest rates. During the global recession in 2008 most of the conventional banks collapsed and had to be rescued by the government (Yuksel & Erturk, 2013). This is ad a result of depending on the interest rates. The lack of stability in the exchange rates also has negative impacts on the conventional banking as it contributes to the difficulties in operations. The conventional banking is quite aggressive when it comes to the generation of revenue. As a result of this, the customers may end up being charged for services that they are not using or do not need it. This negatively influences the customers as they end up paying more. The comparison of services in the conventional banking is difficult. This is because different services are being offered by different banks in the conventional industry. Transferring the funds from one bank to the other is difficult and hence causing inconveniences to the customers. Deflationary tendencies also affect the growth and development of the conventional banking (Ahmad & Safwan, 2011). The inflations in the market negatively influence the conventional banking. Any inflation may lead to the collapse of the conventional banking and hence impacting negatively on the investors. The conventional banking therefore has disadvantages that may lead to inconveniences to the investors. Advantages of Islamic banking and conventional banking Islamic banking The Islamic banking has some advantages which have contributed to its popularity and growth. The underlying principles of justice play an important role in ensuring that the investors do not bear huge losses on their own. The financier and the beneficiaries usually share the profit or losses. This prevents the situation where the investors are exposed to the burden of risk on their own. The output is usually distributed fairly to all the investors which are unlike the conventional banking where the investors have to bear the risks on their own. Credit worthiness and ability to repay loans are mainly considered in the conventional banking however, this is not the case for the Islamic banking. Much of the focus is usually placed on the worthiness and the profitability of the projects (Ali, et al, 2013). This plays an essential role in ensuring that the small businesses can access the financial services. The Islamic banking incorporated the concep0ts of ethics as well as moral values in their operations. This is attributed to the Shariah laws which promote high levels of ethics and morality. This has positive impacts on the public image of the institutions and confidence of the members of the public. Based on the use of Shariah laws, Islamic banks only finance useful products and services. The funds cannot be used to finance substances such as alcohol or pornography which has negative impacts on the community members. This is therefore an indication that Islamic banking adds value to the community. The predetermined fixed rates are not used in Islamic banking when dealing with their clients (Islam, et al, 2014). The banks instead engage the customers on the ground of their investments. The Islamic banking eliminates the barriers between those who want to save and those who want to invest. As a result of this, the customers can easily access the services of the financial institutions. The Islamic factors usually consider various factors including the rate ceiling which is usually imposed by the central bank. This rate has minimum effects on the loans that are offered by the banks as it is not interest based. The services that are offered by the Islamic banking are much lower as compared to that offered by the conventional banking. These positively influence the ability to attract more customers as compared to the conventional banks. Some of the major banks such as HSBC are opening up branches in Islamic banking due to the advantages that it has. Conventional banks The conventional banks make more profits as compared to the Islamic banks. The conventional banks usually purchase deposits from the depositors and selling at a low interest rate. The amount is then sold at a high rate to the borrowers and hence resulting to profitability. The conventional banks mainly relay on the interest for the purposes of generating revenue. Guaranteed collaterals are usually required by the banks for the purposes of reducing the risks of default. The losses of the bank are not shared with the client who has positive impacts on the ability to encourage the clients to invest through the banks. The conventional banks enjoy huge capital share that is distributed widely and hence reducing the probability of making losses (Ariff & Iqbal, 2011). Conventional banks have years of experience due which puts it at a better position to offer effective services to the customers. The level of technological use in the conventional banks is much higher as compared to the Islamic banks and hence impacting positively on the efficiency of carrying out the operations. The conventional banks do not follow any religious principles when carrying out its operations like the Islamic banks. As a result of this, it has little restriction which impacts positively on the ability to make profits. The relationship between the bank and the customer in the conventional bank is that of a creditor and debtors. As a result of this, the customer is sure that they will receive the same amount that they deposited from the bank which is unlike the relationship between the customers and the banks in the Islamic bank. The customers may not be adversely affected when the bank makes losses and the same principals are applied in terms of interest in case of profits or losses. The conventional banks are not limited in terms of their activities and are only obliged to follow the laws that have been set up in the country (El-Gamal, 2011). As a result of this, the bank can therefore engage in high risk projects which may yield high returns. The flexibility of the conventional banking is therefore important in ensuring that the conventional banks can make huge investments. The conventional banks can therefore achieve growth and development as a higher rate as compared to the Islamic period within a given period of time. Challenges and risks Challenges The Islamic bank faces challenges in terms of the legal support. The Islamic banking has its own laws and regulations and in most cases is treated by the national laws as buying and selling properties and hence attracting double taxation. There is no clear legal support on how the Islamic banks can operate with the companies and hence creating a challenge. The legal system that is used by the Islamic laws is different from that of the legal system. In case of any legal issues, the banks will be subjected to the laws that are quite different from its own laws based on the Shariah laws and hence impacting negatively on its operations. The fear of loss by the depositors is also one of the major challenges facing the Islamic banks. This is considering that the losses are shared among the customers who are inconvenienced. This means that the customers may not receive a lower amount than they deposited in case of any losses. Islamic banking lacks prudential regulations which end up affecting some of its activities (Saoumare, 2012). A conflicts usually arises when the prudential regulations are applied to the IJarah as the term security may be used which makes it non-shariah compliant. The Islamic banking lacks common standards which makes it is difficult to carry out some of the activities effectively. This is considering that the standards are developed by the advisory boards composed of scholars. Each of the banks has its own scholars and hence making the standardization process difficult. The Islamic Scholars may have divergent views with regards to certain products and hence making it difficult for the banks to offer such products to the customers (Ahmad & Safwan, 2011). Delays may also be witnessed in case the scholars are not in agreement with regards to a certain product. In some instances, the Islamic banks have difficulties in finding the Islamic scholars as they are few and operate in more than one bank. This challenge has led to direct effects o the banks as it has made some of the operations difficult. The Islamic banks are usually reluctant to enter into long term transactions with the clients. This can be attributed to lack of availability of liquidity. Although the Islamic banks are based on the concepts of ethics and integrity, there is no proper mechanism to make disclosure to the public in order to prove that the banks are operating in a transparent manner. Risks The Islamic banking usually faces a lot of risks due to the nature of its operations. The operations of the Islamic banks are based on the goods and commodities. The prices of goods and commodities usually go up and down from time to time (Ariff & Iqbal, 2011). The currency rates may also fluctuate from time to time. This creates a risk for the Islamic banks as it exposes it to losses. The sharing of profits and losses among the account holders also contributes to the risk facing the Islamic Banks. The poor payouts may affect the operations of the banks as it encourages withdraws which contributes to liquidity and solvency problems. The equity holders in the Islamic banks are usually at a higher risk of transferring some of their profits to investment account holders. This puts the equity holders at a disadvantage and it discourages the other from utilizing the services of the Islamic banks. Revenue is not guaranteed in the Islamic banks which puts the investors at risk. Collaterals are not collected and hence the direct impacts on the revenue of the Islamic banks. The Islamic banks have a limited control of and management of projects. This exposes the bank to the risk of loses incase the projects are not managed well. Comparison and contrast Profit-wise The conventional banks are more profitable as compared to the Islamic banks. This is because the conventional banks rely on interest and are free to invest in any project. The Islamic banks do not charge any interest and their activities are restricted by the Shariah laws making it difficult to engage in profit making activities (Beck, et al, 2013). The conventional can also engage in risky projects for the purposes of generating revenue and obtaining profits. This therefore increases the chances of the conventional banks to make profits. Currently, the conventional banks have more customers as compared to the Islamic banks and hence increasing their profits. Interest rate The conventional banks thrive by charging the customers interest on loans. The rates may be adjusted from time to time depending on the economic condition. Most of the conventional banks charge an interest rate of between 12-15% (Beck, et al, 2013). This has impacted positively on the ability of the conventional banks to generate more revenue. However, the Islamic banks do not charge any interest as it is forbidden by the Shariah laws which governs the operations of the bank. Instead of charging interests, the Islamic banks usually invest in the money and share the profits with the investors. This enables the banks to generate revenue just like the conventional banks. The conventional banks also invest in projects on top of charging interest but do not share profits. Payment and installments The payment of loans in the conventional banks is usually done in installments. The installments are however dependant on the agreements between the bank and the customers. The interests are usually part of the installments being paid to the banks. The installments are dependent on the amount borrowed. A high number of installments is payable if the amount borrowed is high. In the Islamic banking, the payment of installments is allowed under a principle known as Baialinah (Ariff & Iqbal, 2011). Under this principle, the borrower can pay in installments but no interest rate charged in the installments. The installments are also dependent on the amount. Loan contract and other contracts The loan contract is usually made between the borrower and the Islamic bank. Under the loan contract, the terms of the contract are agreed including the payment period. However, the borrower is only supposed to return the amount borrowed without any interest (Ahmad & Safwan, 2011). Loan contracts are also made in the conventional banks between the borrower and the bank. However, in the conventional banks, the contract includes the interest rates that will be paid to service the loan. The borrower, therefore, pays more than the borrowed amount. In the Islamic banks, contracts can also be made for the purposes of leasing. The terms of the contract has to be agreed by both parties. Service and products The conventional banks usually offer a wide range of products and services to the customers. The services that are offered by the conventional banks include loans, mortgages, investments in real estate (Saoumare, 2012). However most of the products and services that are offered by the conventional banks have interests which are charged to the customers. The Islamic bank also offers the same services including leasing of properties. However, the main difference between the products and services of the Islamic banks and the conventional banks is based on the interest. The Islamic bank does not charge any interest on the products and services that it offers as it forbidden by the Shariah laws. References Ariff, M., & Iqbal, M., (2011). The foundations of Islamic banking: Theory , practice and education. New York: Edward Elgar. El-Gamal, M. (2011). Islamic Finance: Law, Economics and Practice. Cambridge: Cambridge University Press. Saoumare, C. (2012). The principles of Islamic Banking. New York: Routledge. Beck, T. et al. (2013). Islamic vs. conventional banking: Business model, efficiency and stability. Journal of Banking & Finance, 37(2), 433-447. Hanif, M. (2014). Differences and similarities in Islamic and conventional banking. International Journal of Business and Social Sciences, 2(2). Ryu, K. P. et al. (2012). A Comparative study between the Islamic and conventional banking systems and its implications. Scholarly J. Bus. Admin, 2(5), 48-54. Yuksel, S., & Erturk, M. (2013). Casual Link Between Islamic and Conventional Banking: Evidence From Turkish Banking Sector (No. 2013-06). Ahmad, A., & Safwan, N. (2011). Comparative study of Islamic and conventional banking in Pakistan based on customer satisfaction. African Journal of Business Management, 5(5), 1768. Ali, L. et al. (2013). Comparison of Islamic and Conventional Banking on the Basis of Riba and Services: A Case Study of Peshawar Region. International Review of Management and Business Research, 2(3), 837. Islam, K. A. et al. (2014). Examination of Profitability between Islamic Banks and Conventional Banks in Bangladesh: A Comparative Study. Research in Business and Management, 1(1), pp-78. Read More