The Differences between Islamic Banking and Conventional Banking System - Essay Example

The Differences between Islamic Banking and Conventional Banking System Introduction The banking sector is an important part of the economic system in any country. Banks are major actors in the financial system, and their principle role is to direct funds from depositors to borrowers in a systematic manner. Banks provide different kinds of financial services, which act as guidance for customers to know about the opportunities for savings and borrowing. All these functions together contribute towards making the overall economy more efficient. The modern society cannot survive without the existence of banks. Banks are financial institutions that act as safe deposits of people’s savings without which they will have no place to save and will also face the risk of keeping all money at home. Banks also facilitate lending and people can borrow any amount of money they require in any convenient manner. Banks essentially act as intermediary between depositors who lend money to the band and borrowers to whom the banks lend money. The amount that banks pay to the depositors and the amount that they received from the borrowers are both called interest. Both depositors and borrowers can be individuals, families, organizations, governments and so on. Since at any point of time some depositors withdraw their money, many others do not. This provides the banks opportunity to convert short term deposits, which are their liabilities to long term loans which are their assets. The interests that banks pay to their borrowers are less than the interests that the banks pay to their depositors. This difference serves as income of banks all over the world. Although banks play a crucial role in the management of money from depositors and lending money to the needy, banks are also indispensable for national and international payments system. Banks also create money. Individuals, organizations or governments do not only need banks as safe custody of their money, but they all also need to circulate their funds like money getting transferred from “buyers to sellers or employers to employees or taxpayers to governments” (Gobat). In this case too banks play a prominent role. They handle payments like issuing personal cheques to making electronic payments of large amounts between banks. The payments system is a “complex network of local, national, and international banks and often involves government central banks and private clearing facilities that match up what banks owe each other” (Gobat). In today’s era of international trade, most payments are administered instantly. An efficiently managed system of payments is indispensable for a stable and growing economy, and any inefficiency in the payments system can hinder smooth trade and therefore can significantly hamper economic growth. The Islamic Banking system is based on the beliefs of Islam that says that God has endowed man with knowledge, power, talents and wisdom. In return God wants man to act in the manner that will help fellow beings. Based on this religious belief, Islamic banks serve the financial needs of billions of Muslims all over the world. Since payment of acceptance of interest goes against the law of Islam, therefore borrowers need to pay only the amount they have borrowed. The research question of this paper is “What is the difference between Islamic banking and conventional banking system? Considering the immense importance of banks in modern economy, it is necessary to understand the functioning of Islamic banking systems as it caters to billions of customers. Moreover, since the 2008 global economic crisis, Islamic banks are gaining more attention from economists and financial experts. This is because the strict regulations of Islamic banks and their reluctance to indulge in debt trading and speculations make them seem a better solution to the ongoing global crisis. Literature review Islamic banking was launched for the first time in the Middle East almost 40 years back in 1975, the first one being Dubai Islamic Bank in the “United Arab Emirates, Egypt, the Cayman Islands, Sudan, Lebanon, the Bahamas, Bosnia, Bahrain and Pakistan” (Alemu, 445). Today, the total valuation of assets of Islamic banks around the globe is estimated at more than US $ 400 billion as in 2012, and there is an expected growth of 15 percent every year (Alemu, 445). Customer preference The Islamic banking system and the conventional banking system have completely different processes of functioning based on distinct principles. While the former functions following the principles of Shariah Law (Islamic law), the latter has a more non-conservative approach. For Islamic banking, lending money essentially means to enter into partnership business, while conventional banks lend money for the purpose of taking it back with full interest. In Islamic banking, the lender does not exert extreme pressures on borrowers to get back their money. However, although Islamic banks lend money without charging any interest, a minimum amount is charged while entering into an agreement with the borrower. The basic concept of conventional banking is lender and borrower relationship between both bank- depositor and bank -borrower. A study was conducted by Al-Tamimi et al. (2009) to explore the perspectives of UAE customers regarding Islamic banking and conventional banking. It was assessed that service efficiency and bank products are two important criteria for creating reputation of a bank. The study revealed that 70 percent of UAE customers prefer Islamic banking and the major reason is its products while those who prefer conventional banking do so for both products and services (Al-Tamimi, 239). The authors concluded that given the high percentages of customers preferring Islamic banking there is therefore huge potential for its development considering it improves its services. However, the study also revealed that customers do not hold any different perspectives regarding the two systems of banking which is surprising because of the different principles and functioning of the two banking systems. It was concluded that both types of banks should focus more on services like better responses to customer queries, sufficient cash available in cash machines, and efficient and cooperative staff. Another article by Alemu (2012) is based on a study conducted on 322 bank customers from three countries that have both kinds of banking systems like Bahrain, Jordan and UAE. Results show that the major factors that affects customers’ choice of Islamic banks includes gender element like Islamic banks provide separate service for women. The choice of conventional banks is dependent on other significant factors like “better rate of return, accessibility to credit, and SMS banking” (Alemu, 458). Other than products and services, there is a general view that customer’s choice of Islamic banks is more due to religious affiliations although there is no concrete evidence to support this theory. Even though Islamic banks are true manifestations of ethical codes as dictated by the Islamic law, religious factors are not the only motivators for customers to choose these banks. Other factors like employee service, bank reputation and product services also play a significant role in customers’ decision making. In the last three decades, Islamic banking has developed to become popular even among non-Muslim population in spite of its strategies based on Shariah Law. During the ongoing financial crisis, many banks in the Western countries have faced the brunt and collapsed, but Islamic banks have continued to develop in both prominence and size. The general consensus that Islamic banks are mostly favored by Muslims have been contradicted by reports which say that 40 percent of Islamic bank customers in Malaysia and non-Muslims while in UK the figure is 20 percent (Alemu, 445). The major difference between the two kinds of banking systems is the interest factor like the Islamic banks do not charge interests to borrowers, and for depositors there is profit sharing arrangement. Unlike in a capitalistic economy where interest rate remains fixed irrespective of the financial condition of the entrepreneur, under Islamic law interest is prohibited in any form. In capitalism, profit is more like reward for taking risk by entering into business, while from Islamic perspective anyone investing money into any venture should take the responsibility of profit or loss. The prohibition of interests under Islamic law means there is no money lending business, and also since investors are rewarded with profits rather than interests therefore they are encouraged to take active participation in the financial success of business (Alemu, 462-463). Since Islamic banks are also financial institutions like conventional banks, therefore same kind of needs of customers are satisfied by both banks. This means that same kind of assessment measures can be used to judge customers’ choice of either type of banks. Although in general, the selection criteria is mostly same for both Islamic banks and conventional banks, it is nevertheless true that religious affiliation is a important factor that make Islamic banks attractive to customers. According to Lee and Ullah (2011) Islamic banking system is based on specific set of rules and conditions and the banks need to duly comply with Islamic law and regulations. In the recent proliferation of Islamic banks across the globe, the impetus has been their Shariah ruled banking products. If the banks fail to abide by the Shariah law, then they will lose the trust of investors and depositors. According to a study conducted in Singapore, 62.1 percent of Muslims prefer keeping their money in Islamic banks and even if they change banks their preference will be other Islamic banks. On the contrary, only 12.4 percent of the non-Muslims will do the same. Moreover, 20.7 percent of Muslims withdraw their money immediately while 66.5 of non-Muslims do the same. Therefore, even if an Islamic bank shows a weak performance in any year, then the Muslims tend to retain their confidence. However, withdrawal by large number of non-Muslims can create liquidity problem for an Islamic bank which can be enhanced if 20.7 percent of Muslims also withdraw their funds. On the other hand, in a country where Islamic economy prevails, Islamic banks have high levels of liquidity and so their liquidity cannot be threatened even with substantial withdrawals by customers (Gerrard & Cunningham). Islamic inter-bank money market In the 1980s, Islamic banking was introduced in Malaysia with a view to convert the financial activities of conventional banks to Islamic approach. Bacha (2008) in his article explored the money market operations of Islamic banking within a dual banking system. Although Islamic banks performance is based on interest free conditions, however many of the risks attached are similar to conventional money markets. In case of Islamic inter-bank money market (IIMM), interest rate fluctuations in conventional market get transmitted to Islamic banks when they use IIMM for liquidity management. Since prices of IIMM instruments are dependent on those of conventional money markets, therefore Islamic banks issuing IIMM instruments will incur more costs if interests rates in conventional markets increase. Similarly, if interest rates fall then investors of IIMM instruments will be getting reduced returns. Under no condition can Central Bank maintain dual interest rates for Islamic banks and conventional banks in a dual banking system. Customer services As already mentioned in earlier part of this section that services in Islamic banks do not hold much appreciation from customers’ perspective, therefore Chaker and Jabnoun (2010) have explored the hindrances to efficient services in Islamic banks which are flourishing more particularly in the Gulf region. For any banking institution, its services are measured on the basis of five dimensions which are reliability which measures the efficiency of staff performance, responsiveness which assesses how fast and efficiently the staff responses to customers’ queries, tangibility which means the physical facilities and the appearance of the staff, assurance which indicates the knowledge level of the staff and their ability to gain customers’ trust and confidence, and empathy which refers to the behavior of the staff and the attention they provide to individual customers. In the Arab countries, the power structure is such that those who are managers seek loyalty and compliance from those they manage, as well as they maintain social distance from the latter. This system indicates centralized decision making which means decisions are made by those who are far away from customers thus leading to insufficient responsiveness to the public and lack of study of customer interests. This is a major obstacle to efficient customer service since “understanding the determinants of customer loyalty will allow management to concentrate on the major influencing factors that lead to customer retention” (Chi & Qu, 625). Moreover, the executive level people act under rigid environment thereby giving minimum opportunities to first line employees to make any kind of decisions. This discourages the employees to take any kind of approaches on behalf of the customers. Since there is lack of empowerment in the hands of first line employees, they are inhibited to support customers’ views and therefore they find it more convenient and safer to say no to customers. The situation becomes grave more because managerial recruitments are based more on family affiliations and personal connections than merits and qualifications. Perception of Non-Muslim customers In this ongoing global economic recession, the Islamic banking structure is gaining increasing popularity among the non-Muslims across the world due to its broader product services and its ability to stand against the odds of economic recession where many conventional banks are collapsing. The major purpose of Islamic banking system is to manage and distribute finance in the manner that complies with the Islamic laws and principles. The growing popularity of Islamic banks among the non-Muslims is due to its “strict lending principles, reflecting industry efforts to transcend religious beliefs to gain greater market share” (Abdullah et al., 151). The Islamic finance is a combination of Islamic concepts of economics as well as modern lending rules, therefore the banking products of Islamic banks can be convenient both for Muslim and non-Muslim customers. Initially, Islamic banks catered to those Muslims who did not favor the interest system in conventional banks. Gradually, Islamic banks attracted the ultra rich Arabian investors who look for ethical investments. Finally, in this current economic crisis more and more non-Muslim population is looking for less risky ventures since there has been a growing non-reliance on Western approach of financial management. Based on a research conducted on 152 respondents from Kuala Lumpur, Malaysia, Abdullah et al. (2012) have found out that the popular perception is that Islamic banking will control the conventional banking system in Malaysia. This study has revealed that selection of Islamic banks is based more on experience and knowledge of Islamic culture. Likewise, non-Muslims belonging to the age group of 19 – 35 years carry better awareness and knowledge about Islamic economic and finances since various sources of news and information are accessible to them. This means non-Muslim people who are better cognizant about the functioning of Islamic banks will prefer these banks. However, this study cannot be considered as comprehensive since Malaysia being one of the most liberal Muslim countries in the world, the Islamic banks provide almost similar products and services like the conventional banks, and so customer preferences often do not differentiate between the two banking systems. Philosophy of Islamic banking Although in essence, Islamic banks perform same kind of activities like conventional banks providing both are financial institutions, the former perform in the framework of Islamic laws and philosophies. The uniqueness of Islamic banking system that distinguishes it from conventional banks is that the former strives towards a “just, fair and balanced society” (Dusuki & Abdullah, 144). In order to encourage social harmony and to protect the interests of both parties like borrowers and lenders, Islamic banks prohibit interest payments, gambling and unnecessary risks. This approach is more ethical since there lies no undue pressure on borrowers. For instance, the prevailing interest system in conventional banks means borrowers have to pay high rate of interest even if they incur losses in their business. Secondly, Islamic banking promotes brotherhood and partnership which indicates a system of “equity sharing, risk sharing and stake taking” (Dusuki & Abdullah, 144). Therefore, Islamic banking promotes cooperation between lenders who provide funds and entrepreneurs who utilize the funds. Since Islamic banks are regulated by the ethical codes of Islamic law, therefore they cannot finance anything unethical under Islam like breweries, night clubs and casinos. This system of ethical investments has become increasingly popular in the UK since the mid 1970s with companies becoming more conscious about their corporate social responsibilities (CSR). Currently there are 50 retail ethical investment funds in the UK with total funds amounting to about £4 billion in August 2001. This proliferation of ethical investments has generated the belief in companies that by contributing towards social and environmental welfare they can reap larger profits since this will enhance their brand recognition and reputation in the consumer market. According to Dusuki and Abdullah (2007) Islamic banks should focus more on social developmental programs like protection of human rights, community developments, environmental welfare and so on since these banks perform financial activities that are interwoven with social and ethical concerns thereby refraining from investing in any ventures that can be detrimental to society and environment. Comparison with conventional banking system In Islamic economics, money is regarded as only a medium of exchange and is appreciated only for the services and products that can be bought with money. It has no other fundamental values. This means money cannot be increased by storing or depositing in banks because there will be no interests on such deposits unlike the conventional monetary system. In Islamic economic the value of money cannot be increased in any other way other than purchasing goods and services. More than money, it is the human effort and risk taking capabilities that are important for a productive venture. Likewise, when money is loaned to a business it is considered as debt and not capital of the business since there can be no returns. Therefore customers of Islamic banks feel more encouraged to purchase assets with money or invest in business rather than keeping the money as safe deposits in banks. In any economy, people can make investments in two ways. One is active investment where a person invests his own money in a venture and solely enjoys the profits and other benefits. Then there is passive investment where people invest in a project to earn returns but do not take active participation in the functioning of the business. A passive investor can earn in three ways – interests from deposits in banks, interests from securities and bonds purchased, and dividends from shares purchased of a company. In Islamic economy, any kinds of interests are prohibited for religious reasons but the concept of dividends is permissible. From the view of business owners, they can invest own money, issue stocks or borrow money with interest. In Islamic economy, only the first two ways are permissible (Okte, 189). Methodology In order to compare the performances of Islamic banks and conventional banks, a ratio comparison has been made between the two types of banks. Four Islamic banks have been selected for this purpose and they are – 1) Dubai Islamic Bank, 2) Qatar Islamic Bank, 3) Hong Leong Bank, and 4) Maybank. Tables 1 & 2 show loan to deposit ratio and NPA (non-performing assets) ratio of these four Islamic banks. Table 1 :- Loan to deposit ratio Dubai Islamic Bank Qatar Islamic Bank Hong Leong Bank Maybank 2010 90.10 % 116.99 % 53.11 % 44.31 % 2011 85.00 % 166.26 % 58.47 % 57.99 % 2012 88.20 % 135.43 % 73.85 % 42.95 % The following figure is the graphical representation of the above table :- Fig 1 :- Loan to deposit ratio of Islamic banks Table 2 :- NPA ratio (NPA / Total assets) Dubai Islamic Bank Qatar Islamic Bank Hong Leong Bank Maybank 2010 12.20 % 1.03 % 0.13 % 1.47 % 2011 13.80 % 1.10 % 0.11 % 1.72 % 2012 12.90 % 1.65 % 0.13 % 1.10 % The following figure is the graphical representation of the above table :- Fig 2 :- NPA ratio of Islamic banks Next, four conventional banks have been taken for ratio analysis and they are – 1) Access Bank, 2) Hongkong and Shanghai Banking Corporation (HSBC Bank), 3) Lloyds Banking Group, and 4) Standard Chartered Bank. Tables 3 & 4 show loan to deposit ratio and NPA ratio of these four commercial banks. Table 3 :- Loan to deposit ratio Access Bank HSBC Bank Lloyds Banking Grp Standard Chartered Bank 2010 80.85 % 82.88 % 150.55 % 78.29 % 2011 46.18 % 73.81 % 35.66 % 77.17 % 2012 46.58 % 74.28 % 21.15 % 75.17 % The following figure is the graphical representation of the above table :- Fig 3 :- Loan to deposit ratio of conventional banks Table 4 :- NPA ratio (NPA / Total assets) Access Bank HSBC Bank Lloyds Banking Grp Standard Chartered Bank 2010 4.30% 0.85% 2.99% 0.10% 2011 4.39% 0.91% 2.86% 0.15% 2012 1.57% 1.44% 2.10% 0.19% The following figure is the graphical representation of the above table :- Fig 4 :- NPA ratio of conventional banks Like any other business enterprise, it is the level of profit that acts as the benchmark for assessing the performance of a banking organization. However, growth in the level of NPA has a significant effect on the profitability of a banking enterprise since a bank is not legally supposed to consider those accounts as income and at the same time is required to make provisions for such impaired assets. NPA or non-performing assets are defined by the Reserve Bank of India (RBI) as “an asset or account of borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or guidelines relating to asset classification issued by RBI” (Balasubramaniam, 42). The growing popularity of Islamic banks among both Muslims and non-Muslims across the world is evident by their existence in over seventy-five countries. Although the basic functioning principles remain same for all Islamic banks in any country since their motto is to adhere to Shariah or Islamic laws, some of the strategies depend on the social and economic conditions of the concerned country. In developing countries like Iran and Sudan, the functioning of these banks is completely Islamic while in countries where both Islamic and conventional banks coexist, there Islamic banks hold a more a liberal approach. In the past decades, the Islamic banks have provided services to customers using religious doctrines, and today they do not only exist along with conventional banks in Muslim countries but also have branched out in the Western countries the United States, United Kingdom and Australia (Alemu, 445). When Islamic banking system were launched for the first time four decades back there was much apprehension in the economic world regarding its success and contribution to global economy. The initial concern was that the Islamic banking products would provide a misleading picture of conventional banking products. The optimism is high among Dubai bankers as they say that doubt regarding sustainability of Islamic banks is more the issue of concern now as it is fast becoming popular source of income for money lenders. This is because under Islamic rule, the lenders cannot charge interest but they will play active part in enterprises in which they invest their money thereby getting share of profits. According to Afaq Khan, the Dubai-based chief executive of Saadiq, Standard Chartered’s Islamic banking arm, “we are continuing to expand” (Hall). The major reason behind such tremendous success of Islamic banks is that the Muslim popular in the Gulf region prefer becoming customers of Islamic banks because of their Shariah compliant products. Studies conducted by Ernst & Young’s Bahrain-based sharia-compliant advisory group have shown that from the second half of 2010 to the first quarter of 2011 there has been a 20 percent growth among the 20 successful Islamic banks in the Gulf region. In the same period, there has been only a 9 percent growth among the conventional banks in the same region (Hall). Like in any industry, the financial advantages are the major reasons behind such rapid popularity of Islamic banks. The rising demand from Islamic investors has encouraged issuers to issue bonds through the Islamic method since this cheaper and convenient than conventional process. In most countries, where there are both Islamic banks and conventional banks coexisting, the latter has the option to provide both Islamic based or conventional based products. This is however an exception in Qatar, where the lender must choose one of the two options. Therefore in Qatar, international banks have shut down their Shariah compliant products and services. According to Razi Fakih, deputy chief executive of Global HSBC Amanah, “customers are increasingly turning to Islamic finance because the proposition is on par with conventional banking” (Hall). The products and services that are offered by Islamic banks are not actually different from conventional system. On the contrary, Islamic banks are implementing two different approaches for developing Islamic financial products and services. According to the first approach, Islamic banks adapt most of the conventional products and services that are compatible with Islamic codes, and then modify or fully eliminates those elements that do not comply with the Shariah law. Then there is the second approach, which means Islamic banks use Shariah principles to innovate and develop new financial products and services. In short, by removing the non-Shariah elements from conventional banking products and services can they be practiced by Islamic banks. The elements that prohibited in accordance with Shariah principles are “riba (interest), gharar (uncertainty), maisir (gambling), non-halal (prohibited) food and drinks and immoral activities” (Alemu, 450). The current global economic crisis has different impacts on Islamic banking system and on conventional banks. Initially in 2008 the Islamic framework of financial activities of the Islamic banks provided a shield to reduce the adverse impact of the crisis on their profitability. In the period 2008-09 there has been a better performance in “credit and asset growth” of Islamic banks than that of conventional banks, thereby leading to financial and economic stability of the former. However, as mentioned in the previous section, centralized decision making creates a wide distance between the management and the first line employees who directly deal with customers. Such management system has resulted in greater decline in profitability in the year 2009 as compared to conventional banks (Hasan & Dridi, 1). The major difference between Islamic banking system and conventional banking system is the risk approach; under Islamic law risk is shared while in conventional system risk is transferred. Under Islamic law, investors share the profits and losses, and the return on the invested fund is not guaranteed as it depends on the financial performance and capability of the bank. In the conventional banks, they are bound to pay interest on the funds deposited by depositors irrespective of low or high performance of the banks in a particular year which means risks of depositors get transferred to the banks. Another very important difference between Islamic banks and conventional banks is that the former does not permit investing in those types of instruments which have negatively affected conventional banks and have contributed towards the current global economic crisis. Such instruments include “toxic assets, derivatives, and conventional financial institution securities” (Hasan & Dridi, 9). Conclusion There is a general view that customer’s choice of Islamic banks is more due to religious affiliations although there is no concrete evidence to support this theory. Even though Islamic banks are true manifestations of ethical codes as dictated by the Islamic law, religious factors are not the only motivators for customers to choose these banks. Other factors like employee service, bank reputation and product services also play a significant role in customers’ decision making. The last 40 years have seen a tremendous growth and development in the Islamic banking system compared to that of conventional banks. Apparently, this is a good sign since Islamic banks have yet just covered less than 30 percent of total market share. In the current economic crisis market, the performances of Islamic banks have been better than conventional banks. This is more pronounced by the fact that many conventional banks have faced heavy setbacks or have collapsed in the US and Europe. There is still a huge chunk of Muslim population especially in India and Commonwealth countries that remains untapped which means there is huge potential for more growth of Islamic banks. Moreover, GCC (Gulf Cooperation Council) countries are yet to achieve the same level of banking penetration like France or the UK. In terms of market achievement, there are established, emerging and untapped markets. The established market is those regions where Islamic banks have made full penetration and holds a significant market share like the Middle East and the South East Asia. Then there are emerging markets which indicate those regions where large Muslim population provide ample opportunity for Islamic banks to flourish and prosper like Pakistan and Indonesia. Then there are countries like India where Islamic banks have not yet penetrated in spite of a huge Muslim population present within the country. Till date, there have been no major strategies to capture the Indian market which need to be focused upon since the Indian market can provide immense scope for expansion (Garbois et al.). In general, irrespective of the type of banking system, there is a consistent rise in expectation levels of customers regarding quality enhancement in financial and personnel services of banks. In order to retain old customers and attract new customers, it is therefore important that every bank focuses on making its service more efficient and effective. The most important element that attracts customers to a bank is its product quality and in this context Islamic countries have an advantage over conventional banks. This is evident in this ongoing economic crisis, as Islamic countries have shown better performance than conventional banks. The reason is the stronger regulatory system of the former and also because Islamic banks do not indulge in market speculation as gambling is prohibited in Shariah law. Today, good financial performance alone cannot retain customer base as social responsibilities are also important in this dynamic world of increasing competition. Based on the customers’ perceptions, bank managers need to understand that social responsibilities and profit maximization need not be conflicting goals. References Abdullah, Abdul Aziz, Sidek, Rokiah & Adnan, Ahmad Azrin “Perception of Non-Muslims Customers towards Islamic Banks in Malaysia”, International Journal of Business and Social Science, 3.11 (2012) 151-163 Alemu, Aye Mengistu “Factors influencing consumers’ financial transactions in Islamic banks compared with conventional banks”, African & Asian Studies, 11.4 (2012) 444-465 Al-Tamimi, Hussein A. 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