Question

Explain the concept, principles and operations of Conventional and Islamic Banking

Answer 1

Definition:

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. Shari'ah prohibits the payment or acceptance of interest charges (riba) for the lending and acceptance of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles. For example, you cannot take a loan for a Wine Shop. On the other hand, Conventional Banking is an Un-Ethical Banking system based on Man-Made Laws. It is profit-oriented and its purpose is to make money through interest”.

The major difference between conventional finance and Islamic finance is that some of the practices and principles that are used in conventional finance are strictly prohibited under Sharia laws. Principles of Islamic Finance which differ from Conventional finance are as follows.

Islamic Finance:

1. Parties entering into the contracts in Islamic finance share profit/loss and risks associated with the transaction. No one can benefit from the transaction more than the other party.

2. Sharia strictly prohibits any form of speculation or gambling, which is called maisir. Thus, Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event.

3.  Islam considers lending with interest payments as an exploitative practice that favors the lender at the expense of the borrower. According to Sharia law, interest is usury (riba), which is strictly prohibited.

4. Some activities, such as producing and selling alcohol or pork, are prohibited in Islam. The activities are considered haram or forbidden.

Whereas Principals of Conventional Banks Mainly based on the man rules and major principals are fixed or set by international financial institutions and governments of the countries in question and do not follow or shift to any religious book or principals to guide them. Banks play the role of intermediary between borrowers and savers or depositors and make a profit on the interest earned on the credit, accorded to the borrower.

Islamic banks operate based on Islamic business law (called fiqh-u–muamalat) for their basic transactions, and they also follow the financial laws and regulations of the countries in which they operate. Conventional banks likewise operate based on a country’s financial laws and regulations, but they don’t have contact with any religious body.

Investments in conventional commercial banks are based on guaranteed principal and earning a fixed amount of income.

For example, say that a customer in a conventional bank deposits $10,000 in a six-month term deposit. After six months, the bank has a liability to pay back the customer the principal plus the interest rate charged for six months. Even if the bank lost the money in an investment, the bank is still liable to pay back all the money due.

In Islamic banking, the concept of investment is different. Although the customer deposits the money in order to earn extra income for her savings, her principal and returns aren’t guaranteed. Suppose the Islamic bank loses money because of an unexpected business failure. In this case, the bank isn’t liable to pay the money to its customers.