HOW DIFFERENT IS ISLAMIC BANKING FROM THE TRADITIONAL BANKING?

Introduction

“Conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money. Islamic law considers a loan to be given or taken, free of charge, to meet any contingency.  Thus, in Islamic Banking, the creditor should not take advantage of the borrower. When money is lent on the basis of interest, more often than not, it leads to some kind of injustice. The first Islamic principle underlying for such kind of transactions is ‘deal not unjustly, and ye shall not be dealt with unjustly’ [2:279] which explain why commercial banking in an Islamic framework is not based on the debtor-creditor relationship” – Ust Hj Zaharuddin Hj Abd Rahman.

Explanations

One must refrain from making a direct comparison between Islamic banking and conventional banking (apple to apple comparison). This is because they are extremely different in many ways. The key difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility is derived from the Shariah law, which leads to the significant difference in many parts of the operations with as of the conventional banking.

The foundation of Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the Shariah in all of its actions and deeds. The original meaning of the Arabic word Shariah is ‘the way to the source of life’ and is now used to refer to the legal system in keeping with the code of behavior called for by the Holy Qur’an (Koran). Amongst the governing principles of an Islamic bank are:

  1. The absence of interest-based (riba) transactions;
  2. The avoidance of economic activities involving oppression (zulm)
  3. The avoidance of economic activities involving speculation (gharar);
  4. The introduction of an Islamic tax, zakat;
  5. The discouragement of the production of goods and services which contradict the Islamic value (haram)

The other principle pertaining to financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk.

Thus, financial intermediation in an Islamic framework has been developed on the basis of the above-mentioned principles. Consequently, financial relationships in Islam have been participatory in nature.

Let’s look at the typical differences as penned down by the Standard Chartered Bank.

Deposit / Liabilities

Conventional banks accept deposits on the basis of loan for all types of deposit accounts including Term Deposit, Savings and Currents accounts. Interest-based returns are provided for the Savings accounts and Term Deposits, whereas Current Accounts may offer free banking facilities. In addition to this, conventional bank invests the deposits in non-shariah compliant avenues and subsequently earns non-shariah compliant returns. Islamic Banks offers deposit products based on the following structures:

1.       Qard – Current accounts are offered under this contract where the risk of the funds lies with the bank and no added benefits are provided to the client solely based on this facility. However, clients may be allowed to avail those facilities which are offered across the board.

2.       Mudarabah – a type of partnership where client funds are invested in various businesses and returns are shared between the bank and client as per the agreed profit sharing ratio whereas, the loss is shared as per the investment ratio. Term Deposit and Savings

Accounts are offered on the basis of Mudarabah.

Lending / Financing

Conventional banks offer lending facilities to their clients to fulfill their cash requirement on the basis of loan contracts where the relationship between the Bank and client is that of lender and borrower respectively.

Conventional Banking Loan Contracts Characteristics:

1.       No risk of underlying assets

2.       Income through Interest

3.       Late Payment charges on delayed payments and shall constitute bank’s income.

Islamic banks offer financing/leasing facilities to their clients to fulfill their business requirements on the basis of following contracts depending on the requirements of the client:

Islamic Banks Financing Transactions Characteristics:

1.       Islamic bank takes the risk of the asset

2.       Income is earned through sale or leasing contracts

3.        Share profit & bear Loss as the case may be

4.        In case of late payment or default by the client, there will be no penal charges. However, to instill a payment discipline, Bank is authorized to recover an amount at a predetermined percentage as a compulsory contribution to Charity Fund constituted by the bank approved Shariah Board. This contribution to Charity Fund shall not constitute income of the bank.

5.        The bank will deploy the Islamic Funds in only Shariah Compliant avenues.

Following are the Saadiq financing products along with their relevant financing structures:

1.       Saadiq Home Finance

Structure: Diminishing Musharakah

A long-term transaction where the bank and the client mutually own an asset and bank earns returns through leasing the asset to the client. In addition to this, periodically client purchases the bank’s share and gradually becomes the complete owner of the asset.

2.       Saadiq Credit Cards Structure: Ujrah

A contract of services, where the bank charges for the provision of associated privileges and benefits. In addition to this, no extra amount is charged over the credit limit utilized by the client.

Saadiq Credit Card restricts usage services at Non-Shariah Compliant merchants.

3.       Business Term Finance

Structure: Diminishing Musharakah Sale & Leaseback

– DM SLB

A medium to a long-term transaction where the bank purchases the partial ownership from the client and jointly owns the asset with the client. The client pays the rentals for using the bank’s share and periodically starts purchasing the bank’s share after a completion of a 12 months period to avoid buyback (which is not allowed as per Shariah). Immediately after the completion of the gradual purchase of share client becomes the complete owner of the asset.

4.       Commercial & Trade

ü  Saadiq Murabaha Finance Structure: Murabaha

Sale based transactions where the bank purchases the asset and bears the risk and reward of the asset and subsequently sells it to the client after adding a certain profit.

ü  Saadiq Term Finance

Structure: Diminishing Musharakah

A medium to a long-term transaction where the bank purchases the partial ownership from the client and jointly owns the asset with the client. The client pays the rentals for using the bank’s share and periodically starts purchasing the bank’s share after a completion of a 12 months period to avoid buyback (which is not allowed as per Shariah). Immediately after the completion of the gradual purchase of share client becomes the complete owner of the asset.

ü  Saadiq Term Musharakah and Overdraft Structure: Musharakah

Musharakah based structure where the bank invests the funds in the clients business on a profit and loss sharing basis. The Bank can take profit on provisional payment basis which would be subject to adjustment when the client’s financial statements are published.

Trade Finance

Conventional banks offer trade finance related operations under the concepts of services, guarantee, and lending.

 

Conventional Banks Trade Transactions Characteristics:

1.       Commission based Income

2.       Income through guaranteeing payments

3.       Income through Interest on loan payments

4.       Additional interest income on delayed payments

Islamic banks also offer trade finance related operations under the concepts of services, guarantee, and financing with the following conditions:

Islamic Banks Trade Transactions Characteristics:

1.       Commission based Income as per the guidelines of Shariah

2.       Income through payment and documents facilitation services

3.       Income through sale or lease of assets

4.       Share Profit & bear Loss as the case may be

5.        In case of late payment or default by the client, There will be no penal charges. However, to instill a payment discipline, Bank is authorized to recover an amount at a predetermined percentage as a compulsory contribution to Charity Fund constituted by the bank approved Shariah Board. This contribution to Charity Fund shall not constitute income of the bank.

6.        The bank will deploy the Islamic Funds in only Shariah Compliant avenues.

Following are the Saadiq trade finance products along with their relevant financing structures:

1.       Saadiq LC Issuance and Import Finance Under Murabaha

Structure: Murabaha under Agency

Saadiq appoints the client as an undisclosed agent to import the goods through LC arrangement and sells the goods to the client after disclosing the cost and profit at the time of receipt of goods

2.       Saadiq LC Issuance Under Kafalah Structure: Kafalah

Saadiq facilitates the client to import the goods and only guarantees the payment to the supplier in case of a default from the client as per the concept of Kafalah. Service charges will be levied on the client to cover the following expenses i.e. Credit assessment procedures, Operational procedures and Processing and issuance procedures. Further, Service charges will be obtained as a fixed percentage of the LC amount based on the duration of the LC.

3.       Saadiq Import Invoice Financing Structure: Murabaha under Agency

Saadiq appoints the client as an undisclosed agent to import the goods and sells the goods to the client after disclosing the cost and profit at the time of receipt of goods

4.       Saadiq Guarantees

Structure: Kafalah

Saadiq facilitates the client as a guarantor against their payment or performance obligations under the concept of Kafalah. Service charges will be levied on the client to cover the following expenses i.e. Credit assessment procedures, Operational procedures and Processing and issuance procedures. Further, Charges may be levied upon fixed percentage basis or can be Tiers/slabs wise.

5.       Saadiq Export LC Confirmation Structure: Kafalah

Saadiq facilitates the client to export the goods and only guarantees the receipt of the payment in case of a default from the buyer as per the concept of Kafalah. Service charges will be levied on the client to cover the following expenses i.e. Credit assessment procedures, Operational procedures and Processing and issuance procedures. Further, Service charges will be obtained as a fixed percentage of the LC amount based on the duration of the LC.

6.       Saadiq Export Bills under LC and Saadiq Export Invoice Finance

Structure: Musawammah & Agency

Saadiq facilitates the client through purchasing the goods on cash and appoints the client as an agent to export the goods to an agency

7.       Saadiq Import Bills for Collection

Structure: Collection Services (Commission based income against services)

Saadiq provides the import document collection services and charges a fee for providing the required services

8.       Saadiq Import Finance Musharkah Structure: Musharakah

Saadiq enters into a Musharakah transaction with the client through investing funds in clients business at an agreed profit sharing ratio and facilitates the client to import the goods. The client utilizes the imported goods in his business operations and shares the agreed returns with Saadiq. Partners bear the risk of loss as per the investment ratio.

9.       Saadiq Export Bills Under Collection

Structure: Collection Services (Commission based income against services)

Saadiq provides collection and forwarding services for the export documents and charges a fee for providing the required services

10.    Saadiq Export Refinance Musharakah: Agency & Murabaha

Saadiq and State Bank of Pakistan (SBP) on joint terms finance run a pool of funds where on behalf of the pool Saadiq appoints client as its agent to purchase goods and later on sells the goods to the client on the basis of Murabaha.

Whatever, returns are generated from the Murabaha transactions are shared between Saadiq and SBP.

11.    Saadiq Export Bills Under LC – Musharakah Structure: Musharakah

Saadiq enters into a Musharkah transaction with the client and invests funds in client business. Client submits the exports bills to Saadiq as a security and shares the returns as per the agreed profit sharing ratio.

12.    Saadiq Export Bills Under LC Goods Murabaha Structure: Agency & Murabaha

Saadiq facilitates the client to avail financing under Murabaha against Export Bills under LC. The bank appoints the client as his agent to purchase the goods and then subsequently sells the goods after disclosing the cost and the profit. The maturity of the bill and murbaha finance is matched, however, if the bill proceeds are not realized, the client is required to pay from his own sources which confirm the exclusivity of both transactions.

13.    Saadiq Pre-shipment Finance Musharakah Structure: Musharakah

Saadiq enters into a Musharakah transaction with the client to facilitate the export orders. Saadiq and client share the returns as per the profit sharing ratio generated from the export proceeds.

14.    Saadiq Invoice Finance Musharkah Facility Structure: Musharakah

Saadiq enters into a Musharakah transaction with the client where both the parties invest together in the business and share the generated returns as per the agreed profit sharing ratio.

 

15.    Saadiq Transactional Commodities Finance Structure: Agency & Murabaha

Saadiq appoints client as its agent to purchases the goods and then procures the goods in a warehouse and subsequently sell it to the client on the basis of Murabaha.

16.    Saadiq Transactional Commodities Finance Structure: Agency & Musawammah

Saadiq appoints client as its agent to purchases the goods and then procures the goods in a warehouse for subsequent selling it to the client on the basis of Musawammah.

17.    Islamic Currency Spot & Promise to Purchase Structure: Wa’d

Islamic Currency Spot & Promise to Purchase product is based on the concept of Wa’d and sale, where initially the buying party enters into a promise to purchase a currency at a future date, however, the actual sale occurs on a future date where an offer and acceptance is executed to conclude the sale transaction.

What is the difference between conventional mortgage financing and Islamic Mortgage financing?

Under conventional mortgage, in order to purchase a property, the customer borrows money and repays it with an additional amount over a period of time. The additional amount is the amount of interest which is against the Shariah rulings of Islam. Under Islamic mortgage finance facility, Islamic bank shares with the customer in purchasing his desired property. Accordingly, the customer and the bank become the joint owners of the property in proportion to their share in purchasing the property. In order to own and use the entire property, the customer purchases the share of bank’s property over a period of time and also pays the rent for using the bank’s share of the property. Over a period of time, the customer manages to purchase the entire share of the bank in the property.

Ultimately, the customer becomes the sole owner. Further, in case of Islamic mortgage finance, the rent will be charged after the lessee has taken delivery of the property and it is in workable/usable condition. Rent cannot be charged from the day the price was paid to acquire the property/asset. If the supplier has delayed the delivery after receiving the full price, the lessee should not be liable for the rent of the period of delay. In case of conventional mortgage finance, normally the lease rentals start from the date the bank make payment for purchasing the property/asset.

Conclusion

Faith is the driving force for Islamic banking while the traditional or conventional banking is based on profit motives. In the case of Islamic banking, which is becoming very popular with the rise in wealth in the Gulf and Malaysia, it is likely to grow around the world without necessarily enforcing Islamic religion on other religions.

2 Comments

  1. Siegfried well done.It is nicely written essay on comparative analysis of Islamic and conventional banking.I appreciate your effort to understand Islamic Banking.The shred risk between borrower and lender in Islamic Banking is of course core value.
    This is humanitarian in nature.Where as the conventional practices put entire risk burden on the borrower who is already in negative economic quadrant.

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