A bank is a financial institution. It plays an intermediary role in the market, accumulating money from one group of people and redistributing it to those in need for effective use. Conventional and Islamic banks share similarities in their fundamental concept as financial institutions, functions, and in many of the services they provide to customers. Both types of banks offer basic financial services such as cash transactions, account keeping, account settlement, and others like exchange, bank transfers, safe deposit boxes, travelers' checks, and bank cards. However, they differ on their concept of operation, operating procedures and policies, as Islamic banks adhere to the norms, rules and principles of Sharia.
Difference between Islamic Banking and Conventional Banking:
Concept of operation
- Conventional
The principle of 'the time value of money' underpins the operation of conventional banks. This principle asserts that a sum of money today is worth more than the same sum in the future due to its potential earning capacity or opportunity cost.
Interest rates, on which conventional banks operate, represent the compensation for the opportunity cost of money, influencing the cost of borrowing. They play a crucial role in the operational decisions and strategies of conventional banks, particularly in lending and borrowing, investment and financing strategies, and the pricing of financial products and services.
- Islamic
Islamic banks operate according to the norms, rules, and principles of Sharia, which guide their concept of operation, operating procedures, and policies.
Islamic finance does not recognize the principle of 'the time value of money'. According to Islamic finance principles, money is not considered a commodity that can generate value on its own. Instead, money is viewed as a medium of exchange and a store of value, but it does not have intrinsic value in and of itself. In Islamic finance, value is derived from real economic activities, such as trade, investment in tangible assets, and productive ventures. Money serves as a means of facilitating transactions and allocating resources, but it does not generate value independently. Profit on the exchange of goods and services is the basis for earning profit.
Operational system
- Conventional
Fractional reserve banking system.
Banks are only required to hold a fraction of their deposit liabilities as reserves, while the rest can be lent out or invested for interest-based credit. This allows banks to generate credit through the process of lending.
Effect:
The expansion of the money supply through the generation of credit, in turn, affects inflation.
- Islamic
Fractional reserve banking system.
However, financing facilities of Islamic banks are invested through various Sharia-compliant mechanisms such as profit sharing, profit and loss sharing, trade-based transactions, or leasing arrangements. These methods align with Islamic principles, which prohibit the charging or receiving of interest (riba) and require financing transactions to be based on tangible assets or real services. It in its turn eliminates expansion of money supply as there is no generation of credit.
Base of operation
- Conventional
Interest (riba) - based crediting
Bank generates income on the difference between interest on loans and interest paid to its customers on their deposits.
Credit rate - Deposit rate = Bank Income
- Islamic
Interest (riba) is forbidden in Sharia.
Islamic bank operates as intermediary between those seeking
financing and its customers providing profit and loss sharing arrangements between the bank and its customers depositing to savings and investments accounts.
Focus of transaction
- Conventional
Credit transaction in order to generate income, and if there is an asset involved in the transaction, it often serves as collateral security rather than being an integral part of the transaction.
- Islamic
Financing real economic activities connected with trade, leasing, or business ventures, where profit is expected to be derived from tangible assets or real services.
Pricing of financial products
- Conventional
Financial products are priced based on the prevailing market interest rate.
- Islamic
The pricing of financing products offered by Islamic banks is directly tied to an underlying asset, commodity, or specified project, with assets required to hold value as per customary trade practices. Assets deemed valueless or without demand cannot be sold or bought, as this would contravene the principles of legitimate trade transactions. Creating an artificial demand to mask financing transactions as trade activities is strictly prohibited.
Loss sharing
- Conventional
Interest-based crediting assumes a positive return to the creditor regardless of the borrower's business venture. The same applies to the case with conventional banks where the borrower is the bank itself and the creditors are the depositors.
- Islamic
The profit and loss sharing principle of Islamic banks' saving and investment accounts assumes that both the profit and the loss are shared if the bank suffers a loss.
Ethical guidelines and Investment restrictions
- Conventional
No ethical or other restrictions apply unless outlined in the bank's policy. Exceptions include mission-driven banks, such as green banks, which generate income by financing clean energy solutions and supporting similar initiatives.
- Islamic
The ethical guidelines and restrictions of Islamic banks are based on Sharia, which prohibits interest (riba), speculation, gambling, and financing and investment activities that are directly prohibited by Sharia, such as alcohol, pork, and gambling, as well as other activities derived from Sharia, such as pornography and drugs.
Pivotal components of Islamic banks are the Shariah Board and Sharia review and audit divisions. The Shariah Board, comprising Islamic scholars well-versed in Sharia and finance, serves as more than just a body that provides approval to financing products. It acts as the moral compass of the bank, ensuring compliance with Sharia principles, and provides guidance and recommendations on remedying any issues of Sharia non-compliance. The Sharia review and audit divisions scrutinize the bank’s contracts and practices to ensure they are in line with Sharia guidelines. Both components play a crucial role in maintaining the integrity and credibility of Islamic banks, further strengthening their dedication to ethical and responsible financial management.
As seen from the comparison of conventional and Islamic banking, they only share similarities in the concept of being financial institutions. However, they differ significantly in their concept of operation, operational systems, bases of operation, focus of transactions, pricing, and other aspects. The ethical guidelines and restrictions imposed by Sharia make Islamic banks unique in their policies, focusing on sustainability, environmental friendliness, social impact, and community development. Islamic financial institutions potentially offer a more enduring model due to their unique principles and practices, which also promote a more stable and sustainable economy.
