10. Islamic vs. Conventional Banking[1]

8/20/2019 10. Islamic vs. Conventional Banking[1]

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Islamic and Conventional

Banking


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Summary of the Previous Lecture

We studied the concept of time value of money

•In the conventional economic system and its

basis on interest at a fixed rate

•!nder Islamic economic system it is based on

price for a commodity "ith a difference for cashand credit sale


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Learning outcomes

#fter today$s lecture you "ill be able to understand

•%he governing principles of Islamic banking based on the

literature mostly discussed in the &nd and 'rd lecture

•(a)or difference bet"een the Islamic and conventional

banking system

•(odes of financing or products offered by the Islamic

banks


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Basics of Islamic Banking

• Islamic Banking is based on Shariah La"s

• Shariah covers every aspect of our life* it provides

principles ho" to live at individual level* in the society*

legal and economic system* etc or simply it is a

complete code of life


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+overning principles of Islamic Banking

, %he prohibition of interest or riba based transactions

& #voidance of speculations -gharar.

' #voidance of oppression -/ulm.

0 Introduction of Islamic tax -/akat.

1 2inancing of Sharia #pproved activities and

discouraging the production of goods and services

"hich are not allo"ed in Islamic values -haram.


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, %he prohibition of interest based

transactions

%hose "ho charge usury -riba$3interest. are in the same

position as those controlled by the devil$s influence %his is

because they claim that usury is the same as commerce

4o"ever* +od permits commerce and prohibits usury

%hus* "hoever heeds this commandment from his Lord andrefrains from usury* he may keep his past earnings and his

)udgment rests "ith +od #s for those "ho persist in usury*

they "ill incur 4ell* "herein they abide forever5 -&6&70.


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transactions

• 8iba$ literally means 9increase5 or 9excess5 #n increasein a loan transaction or exchange of commodity accrues

to the o"ner "ithout giving an e:uivalent compensation

in return 2or example

• ;xchanging ,kg of grapes "ith ,1kg of grapes that are

of the same type* :uality and value

• ;xchanging 8s,


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transactions

Prohibition of 8iba "ill promote an economic behavior

"hich is

•economically )ust -value addition.

•socially fair and ethically correct -e:ual opportunities.

Ine:uality is definite in the situation "here the lender is

guaranteed a positive return "ithout assuming any share of

the borro"er$s risk "hereas the borro"er takes upon

himself all sorts of risks in addition to his skills and labor


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transactions

8iba violates the principle of property rights

(oney lent on interest is used either productively that it

creates additional "ealth or other"ise When money used

-together "ith labor and entrepreneurial skills. to produce

additional "ealth* such money lent cannot have any

property rights claim to the incremental "ealth becausethere "as no prior bargain over it Instead =interest$*

demanded a guaranteed return regardless of the enterprise


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transactions

Promotion of profit>and>risk>sharing

%he sharing of risks and uncertainties of the enterprise is

fundamental to Shariah contracts Shariah condemns theact of guaranteeing -even by the entrepreneur. to restore

the invested funds intact


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transactionsLending is a virtuous act

Lending should be a generous act If money is needed

other than for commercial purposes -thus* risksharing.*

such need should not be exploited "here the borro"er is

put under undue burden

#llah says in ?uran 9

Who is he that "ill lend unto #llah a goodly loan* that 4e

may double it for him or his may be a rich re"ard@-176,,.


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& #voidance of speculations -+harar.

• Aefinition of +harar

#n Islamic finance term describing a risky or

ha/ardous sale* "here details concerning the

sale item are unkno"n or uncertain +harar is

generally prohibited under Islam* "hich explicitly

forbids trades that are considered to have

excessive risk due to uncertainty


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• (ost of the Islamic scholars vie" +harar as =bothignorance of the material attributes of the sub)ect

matter of a sale and also uncertainty regarding its

availability and existence

• (a)ority of derivative contracts are forbidden and

considered invalid because of the uncertainty involved

in the future delivery of the underlying asset such as

for"ards* futures and options* short selling* and

speculation


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+harar is prevented "hen transactions are

transparent "ith6

•all details agreed in advance and

•o"nership undisputed

4o"ever* +harar may be tolerated if there is animportant (aslahah or public benefit


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• Preventable uncertainty is present in any contract

sub)ect to risks in the ordinary course of business

Istisna or salam contracts

• Prohibition of +harar is indirectly a risk management

techni:ue in Islam therefore encouraging the exercise of

due diligence and avoidance of contracts "ith high

degree of information inconsistency "ith high turnover

• %reating +harar as risk has its penalties ie trading of

risks therefore is prohibited "here the traded risks may

have been transferable in derivative format


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' #voidance of oppression -/ulm.

• Dulm refers to all form of ine:uity* in)ustice* exploitation*

oppression and "rong doing

• # person either deprives others of their rights or does not

fulfill his obligations to"ards them• Dulm also refers to trading in matters "hich are prohibited

-haram. under Shariah such as6>

a alcoholic drinks3beverages and

b non halal poultry3meat* pork

• #n extension of the social )ustice and fair economics


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Comparison of Islamic "ith

Conventional Banks

Islamic banks

%he functions and operating

modes of Islamic banks are

based on the principles of

Islamic Shariah

Conventional banks

%he functions and operating

modes of conventional

banks are based on fully

manmade principles

-capitalism theory.


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Conventional Banks

Islamic banks

It promotes risk sharing

bet"een provider of capital

-investor. and the user of

funds -entrepreneur.

Conventional banks

%he investor3lender is

guaranteed of a

predetermined rate of

interest or returns


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Conventional Banks

Islamic banks

It also aims at maximi/ing

profit but sub)ect to Shariah

restrictions

Conventional banks

!nrestricted profit

maximi/ation illustrated by

derivatives trading* deposit

multiplication* etc


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Conventional Banks

Islamic banks

In the modern Islamic

banking system* it has

become one of the service>

oriented functions of the

Islamic banks to be a Dakat

collection centre and they

also pay out their Dakat

Conventional banks

Conventional banks do offer

the service of Dakat

deduction but the depositors

are reluctant to pay Dakat

from their accounts in

conventional banks


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Conventional Banks

Islamic banks

Participation in partnership

business is the fundamental

function of the Islamic

banks

Conventional banks

Lending money and getting

it back "ith compounding

interest is the fundamental

function of the conventional

banks (oney is a

commodity and the

motivation


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Conventional Banks

Islamic banks

Islamic banks have no

provision to charge any

extra money from the

defaulters except for

compensation and is used

for charitable purposes

Conventional banks

It can charge additional

money -penalty and

compounded interest. in

case of defaults


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Conventional Banks

Islamic banks

Importance is given to the

public interest or maslahah

Its ultimate aim is to ensure

gro"th "ith fairness

Conventional banks

Banks interest is the main

ob)ective It makes no effort

to ensure gro"th "ith e:uity


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Conventional Banks

Islamic banks

2or the Islamic banks* it

must be based on a Shariah

approved underlying

transaction

Conventional banks

Interest>based commercial

banks don$t care about the

activities being performed

"ith their financing


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Conventional Banks

Islamic banks

Since it shares profit and

loss* the Islamic banks pay

greater attention to

developing pro)ect appraisaland evaluations

Conventional banks

Since income from the

advances3loans is fixed* it

gives little importance to

developing expertise in

pro)ect appraisal and

evaluations 8isks are

transferable at a price

-insurance.


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Conventional Banks

Islamic banks

+reater emphasis on the

viability of the pro)ects

Conventional banks

%he conventional banks give

greater emphasis on

credit"orthiness of the

clients


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Conventional Banks

Islamic banks

Islamic bank can only

guarantee deposits for

deposit account* "hich isbased on the principle of al>

"adiah* thus the depositors

are guaranteed repayment of

their funds* ho"ever if the

account is based on the(udarabah concept* client

have to share in a loss

position

Conventional banks

# conventional bank has to

guarantee all its deposits


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0 Introduction of Islamic tax -/akat.

• Islamic banks perform as their obligatory duty to take

care of the "hole system of Dakat as its principal

religious liability* and they pay Dakat themselves as "ell

• Eaturally Islamic banks "ill be trusted more than the

conventional banks to perform this )ob


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• Islamic banks "ill make sure that funds are used

only in Sharia approved economic activities* eg

businesses of alcoholic goods* narcotics* haram

meat* pork* casinos* and prostitutions* etc

1 2inancing of Sharia #pproved

activities


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Islamic (odes of 2inancing

Participatory (odes, (udarabah

& (usharakah

Sale (odes, (urabaha

& Salam and parallel salam

' Istisna and parallel Istisna

8ent based (odes

, I)arah

& I)arah "a I:tina


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Summary of the Lecture

In this lecture "e covered the follo"ing topics

•+overning principles of Islamic banking

•Comparison of Islamic and conventional banking

practices

• # brief introduction of Islamic modes of financing

10. Islamic vs. Conventional Banking[1]

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Transcript of 10. Islamic vs. Conventional Banking[1]