How is Islamic Banking Different from conventional Banking

by usman26 (student)

University Degree Business and Administrative studies

How is Islamic Banking Different from conventional Banking?

The title of the research proposal is: How is Islamic banking different from conventional banking?

In this proposal it will be highlighted how Islamic banks operate, what types of products and services they offer. In order to come to a conclusion the proposal will provide a brief comparative analysis between Islamic and conventional banks. The fast growth in Islamic banks in past few years makes this research more interesting, as the growth rate is 15% for Islamic banks which is quite higher compared to 3% growth in conventional banks. According to the statistics of international monetary Fund Islamic banking institutions increased from 75 to over 300 in 2005, later on in 2008 the number further rose to around 500. More appealing thing is the estimated value of assets held by Islamic banks which are $4-5 trillion (Financial performance of conventional vs Islamic banks). Quran, Sunnah, Ijma and qayas are the main sources of Islamic law which prohibit from dealing in interest. This proposal will find out that in exemption of interest what other means does Islamic banks use to do business. In the current recession major financial institutions and banks were adversely effected but Islamic banks sustained in the economic downfall and recession, this led to higher interest in doing this project and raised the curiosity to find out the working patterns of Islamic banks. In order to come to a conclusion in this proposal most common products of Islamic banking will be described.

The research shows that Islamic banking is not merely similar to conventional banking system as major differences exist in operation of Islamic banks and other Islamic financial institutions in comparison with conventional banks. Hanif & Iqbal, categorized financing acording to Islamic approach under two heads: Sharia compliant and Sharia based. Sharia compliant products represent financing models with predetermined and fixed returns but these are bound within Sharia constraints. Tools used in Islamic banking that harmonize with conventional banking include Murabaha (cost plus profit sale), Ijara (a rental arrangement), Bai Salam (spot payment for future delivery), Bai Muajal (sale on deffered payment), Istasna (order to manufacture) and diminishing Musharaka (house financing) which all are Sharia compliant products. As these transactions are Sharia based therefore financing methods that Islamic banks use are on the basis profit and loss sharing. The two ways in which profit and loss is shared include “Musharaka” which is partnership in capital and second is “Mudaraba” in Mudaraba Islamic banks become partner of both capital and skill. Returns of investor in Sharia based financing are not fixed in advance instead of that it depends upon the project’s outcome. On the other hand if any loss is faced then that is shared on the basis of capital contribution. Islamic banks have been able to create trust in the eyes of costumers on the basis of profit and loss sharing instead of interest even though investment options are limited to Islamic banks as compared to conventional banks. (International Journal of Business and Social Sciences, 2011).

Islamic banks collect deposits from savers like conventional banks however the difference exists in the agreement of reward. Under Islamic banking reward is higher on long term deposits and lower on short term deposits although same is the practice adopted by conventional banks but difference lies in sharing of reward and risk. As in Islamic banks depositors who tend to save become participant in profits of the bank However some Islamic scholars also say that banks can pay bonuses to such depositors (Muhammad Hanif,2011)..

Facility of Credit cards is not provided by Islamic banks instead of that they provide ...

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Facility of Credit cards is not provided by Islamic banks instead of that they provide the commodity on demand with additional charges. Islamic bank account holders still get the facility of using debit cards in which they can avail the credit balance in their account. Short and medium term loans are provided by Islamic banks after checking the profitability of the business because under sharia based schemes Musharaka and Mudaraba Islamic banks become participant in profit and loss of the business. However conventional banks have easier terms for short term loans. .

Islamic banks are not allowed to charge extra money from defaulters. If they charge extra money from defaulters they are bound to use that money for charity purpose. Therefore main aim of Islamic banks is to ensure equity and growth (Zaharuddin and Abd Rehman,2007)

Long term and short term agricultural loans are provided by Islamic banks. Instead of charging interest Islamic banks provide these loans under Bai Salam, this basically is buying of crop from farmers by bank instead of interest charged on loan. Mezaan bank is Islamic bank operating in Pakistan and they have introduced agricultural loans in which they will provide guidance, soil testing and latest equipment to farmers for better yielding of crops. Again the reason for such support could be share in profit and loss (Pakistan Today, 2012).

Performance of Islamic banks has been better in recent economic crisis. Main difference found in Islamic and conventional banks was that liquidity holdings were increased by Islamic banks during the crisis relative to conventional banks (Islamic vs. Conventional Banking, October 2010)

In the research it was also found that some conventional banks including HSBC and Halifax provide services that are similar and are according to Sharia Law. This shows clear resemblance in some services of Islamic and conventional banks (Amanah Home Finance)

Thorsten Beck said that many Islamic banks are offering products falling within Sharia compliant and resemble quite allot with conventional banking. This raises question that whether Islamic banks are doing something really different? Many Islamic religious scholars including Professor Amir Chisti said that Islamic banks are using label of Islam and still not following complete Islamic principles of financing. This raises the controversy and might come up with some problems in future for Islamic banks. Detailed research can be done on the topic “whether Islamic banks are really working according to complete Islamic principles?”

From the research carried out so far financing based on Sharia can be considered major difference between Islamic and conventional financing. Sharia law bounds Islamic banks from charging interest and taking profit on lending money without accommodating a level of risk. However conventional banks do not participate in risk of the project.

Research also makes clear that better performance of Islamic banks in recession was not mainly because of any difference in operations but in fact Islamic banks kept their liquidity holdings higher. Another reason found for better performance of Islamic banks is found to be the clauses of Sharia law that prohibit from dealing in toxic assets such as derivatives.

By looking at the example of providing agricultural loans (Mezaan Bank) and provision of goods or commodities instead of credit cards, it can be seen that Islamic banks are also coming up to be more like a trader, by buying and selling goods instead of dealing in interest with their clients unlike conventional banks.

We have seen in research that some conventional banks have also started providing some services according to Sharia such as amanah account by HSBC it can be assessed that in future other conventional banks might come up with similar services which is more likely to reduce the differences between Islamic and conventional banks.

Research of Thorsten Beck concludes to the point that many products of Islamic banks resemble to conventional banking, but still Thorsten beck didn’t claimed that Islamic banking is same as conventional banking, although similar products are provided but the difference lies in sharing of risks and reward. Possible reason for this could be that Islamic banks are operating in the same capitalist system like other banks therefore in order to sustain in the market they might be providing such products.

The area of conflict found in the research is that whether Islamic banks are operating according to complete Islamic principles as the example of Professor Amir Chisti supports this view. Research lacks in evidences and information that whether Islamic banks are operating completely on Islamic principles or not. Detailed research is recommended to find out the answer to this question. Research on this topic is recommended to clear the doubts as in future this might raise questions for Islamic banks by Muslim costumers which are the majority clients of Islamic banks.

To come to a conclusion and drawing all points together it can be observed that the way Islamic banks operate is unique and at the same time it is not anomalous. Major difference found in Islamic and conventional banks is not mainly in products they offer but difference exists in the way costumers are treated. Many services resemble between conventional and Islamic banks but major difference lies in sharing of risk and reward along as no interest is charged. As it is identified that some similar products are provided by Islamic and conventional banks, therefore empirical analysis is required to find out clear differences in business orientation, asset quality and stability of both banks. Data available for research from Bank scope can be used to clear out the differences in business orientation and stability of Islamic and conventional banks,this will be helpful to bolster the research.

Bibliography

Melbournecentre.com.au (2012) Financial Performance of Islamic Vs Conventional banks. [online] Available at: http://www.melbournecentre.com.au/Finsia_MCFS/2009/Papers%20for%20website/Ariff_Conventional_vs_Islamic_Banks_Performance.pdf [Accessed: 26 July 2012].

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine, (2006) Bank concentration, competition, and crises: First results. Journal of Banking and Finance 30, 1581-603

Zaharuddin.net (2007) Differences Between Islamic Banks & Conventional. [online] Available at: http://www.zaharuddin.net/index.php?option=com_content&task=view&id=297&Itemid=72 [Accessed: 17 Aug 2012]

Amanah Home Finance: Shariah compliant finance | HSBC UK . [ONLINE] Available at: . [Accessed 26 july 2012].

international journal of business and social sciences (2012) difference and similarities in Islamic and conventional banks. [online] Available at: http://www.ijbssnet.com/journals/Vol._2_No._2%3B_February_2011/20.pdf [Accessed: 11 August 2012]

Suleman, I. (2012) Meezan Bank becomes largest Islamic Bank of Pakistan. Pakistan Today, 11 August, p.4.