What is Islamic Banking?
Islamic Banking is based on the principles of Shariah Law. In Islamic banking interest is prohibited, it is asset-based financing where the trade of elements is not permissible by Islam. Conventional Banking is based on the Man-made laws and the banking system is profit-oriented.
The purpose of conventional banking is to make money through interest. It is not based on the Sharia laws but is governed by the banking regulations of their respective countries. The risk-sharing factor is different in Islamic banking and conventional banking. The factors of risk management and risks in financial markets are different in Islamic banking and conventional banking.
In Islamic banking, there are two different forms of bank finance and Islamic securities which is also called Sukuk. Whereas in conventional banking these are called as bank loans and bond issues, these categories are not applicable to Islamic finance.
Interest vs Profit
As interest is prohibited in Islamic banking if an organisation is financed by debt with a duty to pay interest, the risk of loss is not shared fairly. According to Islamic finance, the financing activity is done based on the principle of profit and loss sharing. Under the Shariah law, the financing activity is done with different types of contract. In Shariah law, mudarabah specifies how profits and losses are shared between entrepreneurs and financial institutions.
The profits are shared at a predetermined ratio so that returns in business change according to the business profitability. Losses will be borne by the financial institution. On the other hand in conventional banking, the financial institution has the right to receive interest on the loans issued irrespective of the business performance.
How does Sharia Law work?
Islamic banking would share both the profits and losses. The shariah law does not abolish risk; it understands that business is risky and banks should manage that risk and maintain risk which is manageable. Islamic banks also ensure that risk is not speculative in nature as speculative risk is prohibited in Sharia law. To reduce the risk, Islamic banking uses investigative tools and keeps monitoring the business for which they provide finance.
Islamic banking is based on ethical principles from sharing risk, sharing profit & loss and performing real activity. In Islamic banking, there is no facility of using financial instruments like derivatives where the value of an asset would depend on the other performing asset.
Experts say that Islamic banking operates on Islamic profit and loss sharing. Islamic banks and Sukuk are based on contracts which are in accordance with the shariah law. It is based on sharia principles and the sharia board consists of Islamic scholars who give views on Islamic business contracts. In banks, the Sharia board also provides supervision so that the bank operates according to the Sharia principles.
Differences between Conventional Banking System and Islamic Banking System
The following are the differences between the Conventional Banking System and Islamic Banking System.
| Conventional Banking System | Islamic Banking System |
| Money is a product and source of exchange which has a value to trade. | The asset is a product and money is just a source of exchange. |
| Interest is charged based on the time period for which loan is taken. | The profit earned on trade is the main source of generating income. |
| Loss sharing is not applied in conventional banking | Losses can be shared if an entity incurs a loss. |
| Interest is charged irrespective of business performance | There is no concept of interest and losses are shared under Islamic financing. |
| There is no agreement for exchanging goods and services during the cash disbursement for operating finance. | According to Murabaha, Salam and Istisna contracts while disbursement of funds the agreement for exchanging the goods and services is mandatory. |
| There is no presence of goods and service during the disbursement of funds. Money expansion may create inflation. | There is a presence of goods and service during fund disbursement. Since money is not expanded there is no inflation which is created. |
| The business entity increases the prices of goods and services because of the inflation. The cost of the product includes the inflation aspect in determining the price. | There is high control over inflation and no extra prices are charged by business entities. |
| Long term financing and bridge loans are not processed on the basis of capital goods. | Prior to disbursement of cash Musharakah and diminishing Musharakah deals are done and it makes sure that capital is available for the project. |
| The regulatory authorities get loans from the central bank and with money market operation and this is done without initiating the capital expenditure. | Once the delivery of goods is confirmed to the National Investment fund, the government can get loans from monetary agencies. |
| Money circulates among few hands and there is no real growth. | Since real wealth goes into many hands and money circulates in different people there are multiplying effects of real wealth. |
| If the loan is not paid then it becomes a non-performing loan and it is written off. | If the project is unsuccessful, the management decides to transfer the ownership to another entity to overcome the losses. |
| Debt finance has interest expenses which are part of taxable income and it causes tax burden on salary individuals and because of this savings income is severely affected resulting in a reduction of gross GDP. | Profits are shared in Mudarabah and Musharakah and it results in reduced burden over salary individuals and this will increase the savings and also the income of the individuals showing a growth of GDP. |