Conventional Banking Vs Islamic Banking—Comparative Analysis of the Dynamics of Operations

National Seminar on “Future of Financial Markets” in Centre of management Studies Jamia Millia Islamia, New Delhi

Date: 5th September 2011

ISBN: 978-81-922331-0-9, Page no. 609-602 in Seminar Proceeding 1

Conventional Banking Vs Islamic Banking—Comparative Analysis of the

Dynamics of Operations

MatloobUllah Khan

Research Scholar Department of Management

JamiaHamdard, New Delhi, India Email: [email protected]

Dr. ReshmaNasreen and Dr.SadafSiraj

Assistant Professor Department of Management

JamiaHamdard , New Delhi, India

Email: [email protected],[email protected]

Abstract:

Main objective of this paper is to study the basic concepts of Islamic banking and

analyze the working mechanism of both types of structures (Islamic and Interest

based) along with the possibility of Risk factors in both model. This paper also shows

the basic differences between Interest and Islamic based banking system in terms of

profit earning function.

Keywords: Islamic Banking and Interest based banking




Conventional Banking Vs Islamic Banking—Comparative Analysis of the

Dynamics of Operations

Introduction

The financial market in general is a highly leveraged market. History of Wall Street

Crashes and the most recent Lehman Brothers is witness to the follies of over

speculation. Most of the banking and financial activities are based on Interest rate

structure, under such complicated condition. The concept of Islamic banking

generates new innovation in the field of financial activity for those people who are

not interested in receiving interest, or not interested to put their money in interest

based organization. Basically the concepts of Islamic Banking focus on the

community of those people who believe in Islamic Law (Shariah). According to the

Islamic Law, Interest (Riba) „receiving and giving‟ both are prohibited or in Islamic

language it is coded as „Haram‟. This poses a question from people who are skeptical

of the concept of Islamic banking and they ask how can a bank survive without

interest. But when you see the Islamic rules and regulations which are given in

“Quran” related to trade and business; Islam only allows those business and trade in

which both Profit and loss go hand in hand. If an investor or the owner of business

only gets profit instead of loss, it is prohibited (Haram) in Islamic law, if they get

profit as well as losses, it is acceptable (Halal). If the level of risk factor is minimum,

it is also acceptable. It means risk factor should always carry with the business

according to Islamic law otherwise that business is prohibited (Haram).




Concept of Islamic banking

Definition –Islamic banking is a system which follows the rules and regulation

depend on the principles of Islamic law (Sharia), which is called ‘fiqh al-

mumalat’1(Islamic rules on transaction) which are given in „Quran‟ and different

„Hadies‟2.

Some of the basic concepts of Islamic banking are given blow with explanation

Wadiahor Amanah (Safe keeping): This is an agreement between bank and a

customer, in which customers deposit their money &tangible assets (gold, silver and

Diamond, etc.) in a bank for the purpose of safety and if any time, a customer wants

to receive their amount and assets, the bank returns their assets. On such kind of

services bank charge some amount of fees from the customer according to the

predetermined agreement. On „Amanah’ agreement Islamic bank also provide other

kinds of services such asclearance of cheque, M-Banking, E-Banking, Deposits of

fund, Foreign exchange service and Cash withdrawal service. On that deposit balance,

when customer give permission to the bank to invest that amount in any feasible

project, the bank gives profit to customer in the form of „Hibah‟3

(gift). It‟s

applicable; when project is in profit, otherwise they share losses also.

Mudharabah (Profit sharing): This is an agreement between two persons one is the

investor who invests money in the project and other is the entrepreneur or manager of

a particular business or project, one person gives his fund to another person for the

purpose of diversification of existing business or to start a new business and share

1- See ‘Hassan k. and Mahlknecht M’. (2011), P: 311-314 2-In Islamic terminology, the term ‘hadies’ refers to reports of statements or actions of Muhammad, or of his tacit Approval of something said or done in his presence. 3- Hibah (gift) is the gratuitous transfer of a property to another party without any material consideration.




profit and loss on the basis of agreement. Islamic banking uses this concept in the

form, of putting itself between two parties. Under such kind of working concept bank

creates two deals one with the capital investor (owner of the fund) and other with the

capital receiver (Entrepreneur or manager of project). If investor is also interested to

Know where his money will be invested, the bank will give information related to

business, where the money is to be invested.

Murabahah (Sale of goods at a price which include profit margin): In that concept

bank purchases goods from one party in large number of quantity and sells those

goods to another party by adding some profit margin which will be paid by the

purchaser either fully or in proper installment which is specified in written agreement.

Musyarakah (Joint venture between bank and entrepreneur): In that concept both

the party Bank and Entrepreneur contribute capital and share profit and loss on the

bases of contributed capital. In that case entrepreneur should contribute at least 30%

equity capital and bank contributes the remaining 70% equity capital. Such kinds of

concepts are used in financing the specific project. When project is completed, they

share profit or loss according to the capital investment ratio, with their actual

investment amount.

Istisna (Intermediary): In this concept bank act as a mediator between manufacturer

and purchaser. Bank orders the goods to purchase on behalf of the purchaser, gives

full payment to manufacture and sells same goods to the purchaser or customer along

with profit margin (cost plus price) which should be paid by the customer in lump

sum or in installment to the bank, accordingly to written agreement.

Salam (Advance payment): Salam process includes advance payment for goods

before its delivery, it means delivery of goods will be in near future after two or three

month which are given in contract but the payment should be made in advance. This

concept is used to promote forward and future market for purchase and sell of




commodities, Salam process involves two different agreements- one between

purchaser of commodity and the bank another with the seller of commodity and the

bank.

IjarahThumma Bal (Hire Purchase):Ijarah Thumma are used to purchase high price

assets with the help of Bank, specially motor cars and other heavy equipments. This

concept works in such a way, that if a person wants to purchase car, he goes to a bank

for finance and the bank agrees to purchase that product on behalf of customer. The

bank makes an agreement with the customer that after some time they will purchase

the same product with some cost plus price or pay rent in the form of installment.

When the final installment along with some agreed profit (as per the agreement

clause) has been paid to the bank, the ownership of the car or heavy equipment is

transferred to the customer. During that period bank makes two agreements one at the

time of purchase of assets and another at the time of sale of the same assets.

Rahn (Mortgage and Pledge): Rahn means mortgage something in the Bank against

of finance which is provided by the Bank. The person who takes finance from the

bank for a particular project, the same person mortgages something in the bank in

against of that finance, so such kind of activity reduces the risk factor of bank related

to financing. If client is not able to pay the financed amount due to some default this

amount may be recovered from these mortgages. For example- if a particular person

wants funds to construct or purchase house, he/she mortgages the paper of land/house

to the bank up to the given period of installment which are given in agreement.

Kafalah (Guarantee): In Kafalahguarantee is given by the bank to pay amount to

another party on behalf of other party. For example there are three party A, B and C.




In which B act as Bank, and A & C act as party, if A uses the service of B (Bank), A

issues written document to B (Bank) to pay certain amount to C, B (Bank) acts as first

party and pays amount to C on behalf of A and B (Bank) fulfill the obligation of A

and gives guarantee to C.

Hawalah (Transfer of payment responsibility): In Hawalah Bank takes the

responsibility of payment from one point to another point, means transfer the

responsibility of payment from one party to another party with the condition that

debtor is supplanted by another debtor. For example this concept is used in

discounted bill of exchange or basically the return for a post datedcheque.

Wakalah (Agent): In this concept a particular person appoints Bank on behalf of

himself for a particular task according to the written agreement and Bank works for

that person as an agent and in against of that bank charges some consultant fees.

Quard (Interest free loan): In this concept bank gives loan to its loyal customer or

gives to such kind of people who require financial support to start new business or for

the expansion of existing business on the basis of goodwill. In Quard clients are not

bound to pay any fixed profit but liable to pay actual amount which he/she receives

from the bank. If customer feels to pay some extra amount to bank in respect of that

financial support which he receives, then he/she can give that amount to the bank in

the form of Gift (Hibha) not in the form of interest.

Analysis Model of Interest Based Banking structure:

Model of Interest Based Banking Structure is a combination of different kind of credit

and loan activity, from which bank generate huge amount of profit. Banks also follow

different interest rate structure, which varies from customer to customer (see Model

1).




Model: 1

Normal Structure of Interest base banking In India

Source: Interest rates taken from SBI (State Bank of India) website, Dated 14 February 2011

𝑪𝑪/𝑨

𝒏

𝒊=𝟏

𝑪𝑺/𝑨

𝒏

𝒊=𝟏

𝑪𝑭𝑫

𝒏

𝒊=𝟏

∈ 𝑪𝑪/𝑨

𝒏

𝒊=𝟏

+ 𝑪𝑺/𝑨

𝒏

𝒊=𝟏

𝑪𝑹𝑫

𝒏

𝒊=𝟏

∈ 𝑪𝑪/𝑨

𝒏

𝒊=𝟏

+ 𝑪𝑺/𝑨

𝒏

𝒊=𝟏

BANK

S/A Dept. C/A Dept. FD & RD Dept.

Loan Dept.

Generate Funds

𝑪𝑬𝑳

𝒏

𝒊=𝟏

𝑪𝑯𝑳

𝒏

𝒊=𝟏

𝑪𝑪𝑳/𝑩𝑳

𝒏

𝒊=𝟏

𝑪𝑳𝑨−𝑵𝑺𝑪/𝑲𝑽𝑷/𝑹𝑩𝑰−𝑹𝑩/𝑳𝑰𝑪/𝑴𝑭.𝒆𝒕𝒄

𝒏

𝒊=𝟏

𝑪𝑶𝑫/𝑾𝑪𝑳

𝒏

𝒊=𝟏

𝑪𝑳𝑨−𝑺/𝑫/𝑩

𝒏

𝒊=𝟏

𝑪𝑳𝑨−𝑮𝑶

𝒏

𝒊=𝟏

𝑪𝑳𝑨−𝑴𝑷

𝒏

𝒊=𝟏

𝑪𝑷𝑳−𝑺𝑪𝑯

𝒏

𝒊=𝟏

8.5%

3.5%

4% to 9%

NA

12%

to

13.5%

9.75%

to

10% 11.%

to

16.5%

13.5% to 13.75%

12.5%

to

13.%

14.75%

16.50%

15.% to16.75%

12.75%

𝐶𝐵−𝐵𝑜𝑛𝑑 ∈ 𝑃𝑐𝑖𝑡𝑦 𝑎𝑙𝑠𝑜

𝑛

𝑖=1

9.75% to 9.95%




Product/service offerings of conventional banks

Now a day‟s definition of banking is changed, bank has become a function of

multidimensional services. It follows the concept of commercial bank, means all kind

of services provided under one roof, so on that basis profit of bank also increases but

still most of their profits are generated from loan department.

Function of Modern Banking (MB) includes various kinds of activities some of its

important function are:

𝑴𝑩 = 𝒇(𝑳, 𝑰𝒊𝒏𝒔𝒖,𝑭𝑫,𝑪𝑨/𝑪,𝑺𝑨/𝑪,,𝑩𝑬𝑿,𝑫𝑫𝑹,𝑪𝑬𝑿,𝑴𝑭,𝑳𝑭,𝑭𝑫𝒃𝒖,𝑺𝑺𝒂𝒍,𝑫𝑴𝒔𝒆𝒓𝒗,𝑪𝒄𝒂𝒓𝒅,𝑫𝒄𝒂𝒓𝒅 ,𝑻𝒄𝒉) ..(1)

Where:

MB=Modern banking, L=loan, FD=Fix Deposit,Iinsu=Insurance,

CA/c=Current Account,SA/C=Saving Account,BEX=bill of exchange,

DDR=Demand Draft,CEX=Currency Exchange,MF=Mutual fund,

LF=Locker facility,FDbu=Form Distribution, Ssal= Share sale(IPO/NEW Issue),

DMserv=Dematerialized service, Ccard=Credit card, DCard=Debit Card, and

Tch=Travel Cheque.

From the above function bank generate profit, Then profit of the Bank (PBank) are:

𝑃𝐵𝑎𝑛𝑘 = 𝑓 ∆𝐼 + 𝑓 𝑆𝑐𝑕𝑎𝑟𝑔𝑒 − 𝑓(𝐵𝑒𝑥𝑝 ) …………(2)

Where:

∆𝑰=Difference in Interest Receive and paid, Scharge= Service charge, Bexp=Bank expanses.

Service charges include all those function of bank in which bank charges its fees. For

example on loan approval bank charges one percent to two percent as a file

processing fees. Bank expenses include all kinds of expenses such as tax, Employ

salary, maintenance charges, building charges, and rent of assets etc. But our study is

only related to interest rate structure of normal banking.

So, the function of Bank profit from interest given by relation:

𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑓 ∆𝐼 ….. (3)




Or 𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑓 𝐼2 − 𝐼1 …..(4)

Where I1=Interest paid by bank, and I2= Interest receive by bank

Or𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑓 𝐼2 − 𝐼1 =

𝑖𝑓, 𝐼2 = 𝐼1, 𝑡𝑕𝑒𝑛 𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 0,𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡,

𝑖𝑓, 𝐼2 < 𝐼1 , 𝑡𝑕𝑒𝑛 𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝐿𝑜𝑠𝑠,………………… . .

𝑖𝑓, 𝐼2 > 𝐼1, 𝑡𝑕𝑒𝑛 𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝐺𝑒𝑛𝑒𝑟𝑎𝑡𝑒 𝑃𝑟𝑜𝑓𝑖𝑡, .… . .

In above three cases, interest base banking always tries to maintain I2>I1in

eachand every condition or at any cost, otherwise it can‟t able to survive in

conventional banking system.

Or 𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑓 𝐼2 − 𝑓(𝐼1) …(6)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑓 𝐼2 𝟒 = 13.75% and𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑓 𝐼1

𝟓 = 7.21%

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝐵𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 13.75% − 7.21% = 6.54%

From 6.54% average difference in interest, bank generate huge amount of profit

(See Table 1.1)

Table 1.1

Profit & Loss account of State Bank of India

------------------- in Rs. Cr. -------------------

Mar '07 Mar '08 Mar '09 Mar '10

12 mths 12 mths 12 mths 12 mths

Income

Interest Earned 39,491.03 48,950.31 63,788.43 70,993.92

Other Income 7,446.76 9,398.43 12,691.35 14,968.15

Total Income 46,937.79 58,348.74 76,479.78 85,962.07

Expenditure

Interest expended 23,436.82 31,929.08 42,915.29 47,322.48

Employee Cost 7,932.58 7,785.87 9,747.31 12,754.65

Selling and Admin Expenses 3,251.14 4,165.94 5,122.06 7,898.23

Depreciation 602.39 679.98 763.14 932.66

Miscellaneous Expenses 7,173.55 7,058.75 8,810.75 7,888.00

Preoperative ExpCapitalised 0.00 0.00 0.00 0.00

Operating Expenses 13,251.78 14,609.55 18,123.66 24,941.01

Provisions & Contingencies 5,707.88 5,080.99 6,319.60 4,532.53

Total Expenses 42,396.48 51,619.62 67,358.55 76,796.02

Mar '07 Mar '08 Mar '09 Mar '10

12 mths 12 mths 12 mths 12 mths

Net Profit for the Year 4,541.31 6,729.12 9,121.23 9,166.05

Source:http://www.moneycontrol.com/financials/statebankindia/profit-loss/SBI, 10 April 2011

…(5)

4- Average Interest receives by SBI (Source: www.statebankofindia.com); 5- Average Interest paid by SBI (Source: www.statebankofindia.com);




Analysis Model of Non- Interest Based Banking Structure:

Model of non-interest based banking structure was generated by Islamic Banking,

which runs on the principle of „Islamic Rules and Regulation‟, which are given in

„Quran’. In this structure Islamic Banks generate profit without using interest rate

concept. (See model: 2). (Refer concepts of Islamic banking)

Basically Islamic Banks operates mainly three categories of accounts; these are

Saving, Current and Investment account. In saving account Islamic banks provide all

kind of services similar to an interest based banking system but only difference is that

instead of interest, it gives „Hibah‟ to their saving bank account holder. „Hibah‟ is a

kind of gift which is given by Islamic Banks to their saving bank account customer in

the form of money. Hibah is not a fixed rate of profit; it goes up and down on the

bases of Islamic Bank‟s performance. Some time Islamic banks give high rate of

return on the basis of their profit, some time they give low or zero rate of return on

the basis of their profit. On current account, Islamic banks don‟t give any type of

Hibah, because on current account banks generate profit with the help of current

account credit policy, such as purchase raw material for current account holder

business. Investment account is a type of term deposit account, in which money

should be blocked up to the completion of project or tenure of project, but in

investment account customer share both profit and loss according to project

performance, which is the basic requirement of Islamic finance, because Islamic law

only accept those investment which involve risk factor otherwise it is not accepted by

Islamic law. Fixed or variable interest rate investment is the part of one sided profit

oriented investment, so it is not acceptable by Islamic laws, which are given in Quran.




Model: 2

Normal structure of Islamic Bank

1. Bank charges fees -Wadiha -Kafalah

-Hawalah

2. P/L sharing -Mudharabah -Musyarakah

3. Cost plus price

-Murabahah

-Istisna

-Salam

6. Higher purchase

-IjarahThummaBal

4. Interest free loan -Quard

Islamic Bank

𝑪𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑨/𝑪

𝒏

𝒊=𝟏

𝑪𝒑𝒓𝒐𝒋𝒆𝒄𝒕 𝒇𝒊𝒏𝒂𝒏𝒄𝒆

𝒏

𝒊=𝟏

2

2

𝑪𝑺𝒂𝒗𝒊𝒏𝒈 𝑨/𝑪

𝒏

𝒊=𝟏

1

𝑪𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝑨/𝑪

𝒏

𝒊=𝟏

1

3

𝑪𝑫𝒂𝒊𝒍𝒚 𝑩𝒖𝒔𝒊𝒏𝒆𝒔𝒔 𝑭𝒊𝒏𝒂𝒏𝒄𝒆

𝒏

𝒊=𝟏

Share Profit and loss

Share Profit and loss

𝑪𝑷𝒆𝒓𝒔𝒐𝒏𝒂𝒍 𝒍𝒐𝒂𝒏

𝒏

𝒊=𝟏

3

Paid cost plus price

4

Paid Hibah if interested

𝑪𝑪𝒐𝒔𝒕𝒍𝒚 𝑨𝒔𝒔𝒆𝒕𝒔 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆

𝒏

𝒊=𝟏

6

Charge

Extra price

Receive Hibhaif Bank generated profit

5. Agent -Wakalah

5

NA for any type of Hibha

Rahn (Mortgage)

4 Paid Hibah if interested




Product/service Offerings of Islamic Banks

Function of Islamic Bank (IB) includes various kind of activity some of their

important functions are:

𝑰𝑩 = 𝒇(𝑷𝑳𝒔,𝑪𝑷𝒑,𝑯𝒑𝒖𝒓, 𝑰𝑭𝑳,𝑯𝒃𝑹𝑷,𝑺𝑨/𝑪,𝑪𝑨/𝑪, 𝑰𝑨/𝑪,𝑪𝑬𝑿,𝑫𝑫𝑹,𝑩𝑬𝑿,𝑻𝒄𝒉)…..(7)

Where:

IB = Islamic Bank, PLs = Profit and loss sharing,CPp = Cost plus price,

Hpur = Higher purchase,IFL = Interest free loan, HbR = HibahReceive and paid,

SA/C = Saving account, CA/C = Current account, IA/C = Investment account,

CEX = Currency exchange, DDR =Demand draft, BEX = Bill of Exchange, and

Tch = Travel cheque.

From the above function Islamic bank generate profit. Then profit of Islamic bank

(PIB) has shown by the relation:

𝑃𝐼𝐵 = 𝑓 ∆𝐻𝑏 + 𝑓 ∆𝑃 + 𝑓(𝑆𝐶𝑕𝑎𝑟𝑔𝑒 ) − 𝑓 𝐵𝐸𝑥𝑝 − 𝑓(𝐿𝑠) . ..(8)

Where:

∆𝐻𝑏 = Difference in Hibah received and paid, ∆𝑃= profit received and paid,

Scharge = Service charges,BExp = Bank expenses, and Ls = Loss sharing.

In conventional banking system, bank receives and pays interest but in Islamic

banking system, bank receives and pays „Hibah‟, and shares profit or loss on project

and on business finance.

Profit of Islamic bank by Hibah and profit sharing given by function:

𝑃𝐻𝑖𝑏𝑎 𝑕 & 𝑃𝑟𝑜𝑓𝑖𝑡 𝑠𝑕𝑎𝑟𝑖𝑛𝑔 = 𝑓 ∆𝐻𝑏 + 𝑓(∆𝑃)….(9)

Or 𝑃𝐻𝑖𝑏𝑎 𝑕 & 𝑃𝑟𝑜𝑓𝑖𝑡 𝑠𝑕𝑎𝑟𝑖𝑛𝑔 = 𝑓 𝐻𝑏2− 𝐻𝑏1

+ 𝑓 𝑃2 − 𝑃1 … 10

Where:

𝐻𝑏2= 𝐻𝑖𝑏𝑎𝑕 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑏𝑦 𝑏𝑎𝑛𝑘 ,𝐻𝑏1

= 𝐻𝑖𝑏𝑎𝑕 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑏𝑎𝑛𝑘,

𝑃2 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑏𝑦 𝑏𝑎𝑛𝑘,𝑎𝑛𝑑 𝑃1 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑏𝑎𝑛𝑘.




If, 𝐻𝑏2increasesby good performance of bank,𝐻𝑏1

will also increase. Similarly if P2

increases by good performance of project or business, P1 will also increase. If

𝐻𝑏2decreases then𝐻𝑏1

will also decrease, likewise P2 decreases, P1will also decrease.

It‟s applied that:

𝑯𝒃𝟐 ∝ 𝑯𝒃𝟏and𝑷𝟐 ∝ 𝑷𝟏…(11)

𝑰𝒇 𝑯𝒃𝟐 > 𝑯𝒃𝟏 𝒂𝒏𝒅 𝑷𝟐 > 𝑷𝟏 ...(12)

From above equations(12) we find that Bank generates profit from ‘Hibah and profit

sharing’, because Islamic bank always try to maintain the situation of equation (12).

Above relation of „Hibah and Profit Sharing‟ concludes that customer from

both side feels comfortable, while using the services of Islamic bank. Loan Customers

are not bound to pay interest but it depends upon the performance of their business

and they have to pay principle amount. Saving and investment account holders also

have a possibility to get high rate of Profit and Hibah on the bases of performance of

bank and its projects. (See table 1.2 and 1.3)

Table 1.2

Profit Rates for the month of February 2011

Percentage per Annum

Tenure Profit rate at

Maturity

Quarterly Rate Monthly Rate

Three month 7.14% -------------- ----------------

Six month 7.41% -------------- -----------------

One year 9.41% 8.34% 8.08%

Two year 9.54% 8.41% 8.14%

Three year 10.14% 8.88% 8.28%

Five year 11.88% 10.14% 9.28% Source: ‘Meezan Bank’ (www.meezanbank.com), 5 March 2011

Table 1.3, is related to profit and loss account of Meezan Bank which runs on the

principle of Islam laws. The profit earning process of Meezan Bank doesn‟t contain

any item of interest based program.




Table 1.3

Meezan Bank profit and loss Account (year ended 31 December 2010

Source: www.meezanbank.com (Financial statement)

Possibility of Risk Factor(𝐑𝐟) in both models:

While analyzing the working mechanism of Islamic banking and conventional

banking comparatively, Risk factor is almost same. Both types of banking have a

concept of Non-performing Assets6, but only difference is that in conventional

banking system Non-performing Assets means installments of loan unpaid along with

6- See ‘ Venardoas A.M. (2005) , P: 157-160, For Non-performing Assets in Islamic bank, and see ‘Jalan P.K. (2005), P:196-200, For Non-performing Assets in SBI.




interest and bank bears losses. In Islamic banking system installment of principle

amount unpaid and investors share losses with bank in case of Investment account,

and in case of saving account bank don‟t give „Hibah‟. (See figure 1.1)

Figure 1.1

In Conventional Banking System

In Islamic Banking system

In both type of system level of Risk factor (𝑅𝑓) depend upon size of loan or credit.

The level of Risk factor should be maintain by using the concept of Mortgage

It‟s applied that:

𝑹𝒇 ∝𝑺𝑳

𝑴𝑽 … (13)

Interest based

Bank

Customer

received

interest

Customer paid

loan amount

along with

interest

Risk factor (𝑹𝒇) lies on Bank only

Customer

received Hibah

and profit

Islamic

Banking

Customer paid

principle amount

along with Hibah

and profit

Risk factor (𝑹𝒇) lies on customer and bank both




Where:

SL = Size of loan; and

MV = Mortgage value;

𝐿𝑒𝑣𝑒𝑙 𝑜𝑓 𝑅𝑓 𝑑𝑒𝑝𝑒𝑛𝑑 𝑜𝑛 𝑡𝑕𝑟𝑒𝑒 𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛, 𝑖𝑓

𝑆𝐿 > 𝑀𝑉 ,𝑅𝑓 𝑀𝑎𝑥𝑖𝑚𝑢𝑚

𝑆𝐿 = 𝑀𝑉 ,𝑅𝑓 𝑀𝑖𝑛𝑖𝑚𝑢𝑚

𝑆𝐿 < 𝑀𝑉 , 𝑅𝑓 → 0

In above three conditions most of the banks follows second and third condition

including Islamic banks, but in case of goodwill (Related to loan customer) banks

also follow first condition.

Conclusion

Structure of Islamic banking is different from Interest based banking structure in

respect to the return point of view. Technically Interest based banking structure is

more risky than Islamic banking structure. The interest based system bank bears all

types of losses, but Islamic based system banks share their losses with their

customers. Therefore, the level of risk in the case of Islamic banking system is

minimum, as the result of the effect, survival chances of Islamic banking is more

positive than that of Interest based banking system.

Books reference:

1. Akgunduz A. 2009. Studies in Islamic economics (Islamic Banking and

Development). Turkey; IUR press publication.

2. Ahmad U.F. 2010. Theory and practice of modern Islamic finance: the case

analysis from Australia. Florida USA; Walker press publication.

3. Bhatia R.C. 1982. Banking structure and performance a case study of India.

National Institute of Banking Management publication.




4. Fealy G. and White S. 2008. Expressing Islam: Religious life and politics in

Indonesia. Singapore; ISEAS publication.

5. Hassan K. and Lewis M.K. 2007. Hand book of Islamic Banking. USA;

Edward Elgar publication.

6. Mahmoud A. and Gamal E.L. Islamic finance: law, economics and practice.

USA; Cambridge University press publication.

7. Murthy D.K. and Venugopal K.R. 2006. Indian financial system. New Delhi;

International publication House.

8. Schoon N. 2009. Islamic banking and Finance. London; Spiramus press

publication.

9. Usmani M.T. 2002. An Introduction to Islamic finance. Netherlands; Klumer

Law International publication.

Journals reference:

1. Abdul-Rahman, Yahia. 1999. Islamic instrument for management liquidity.

International journal of Islamic finance service. Vol-1 No. 1.

2. Aggarwal, Rajesh k, Yousef and Trick. 2000. Islamic banking and investment

finance. Journal of Money, credit and banking. Vol-32, No.1, February, pp

93-120.

3. Al –dehanniTalla, Karim A, Ahnad R and Vector H. 1999. The capital

structure of Islamic bank under the contractual obligation of profit sharing.

International journal of theoretical and applied finance. Vol-2, No.3, pp 243-

283.




4. Ali A. Al-Salous 1988, AI- Murabaha to He who order to purchase: View in

practical work in Arabia, Paper presented to the 5th

conference of Islamic

Figh Academy Kuwait, p 14.

5. Dar, Humagon A, Presleg and John R. 2000, Lack of profit loss sharing in

Islamic banking: Management and control imbalance. Economic research

paper. No 00/24, Lough brough university.

6. Dar H.A and Harney D and Presley J.R. 1999, Size profitability and agency

problem in profit and loss sharing in Islamic Finance. Proceeding of the

second Annual Harvard University Forum on Islamic Finance, Cambridge

MA: Center for Middle Eastern studies, Harvard university Press, pp 51-62.

7. EL-Gamal M. 1999, The survival of Islamic Banking: A Micro-evolutionary

perspective, Proceeding of second annual Harvard University forum on

Islamic finance, Cambridge MA: Center for Middle Eastern Studies Harvard

University Press, pp 63-76.

8. Iqbal M. 1999, Challenges Facing Islamic Banking. Paper presented at the 6th

orientation course in Islamic Economics, Banking and Finance. The Islamic

foundation U.K, pp 17-21 September.

Abbreviations:

𝐶𝑪/𝑨 =Customer current Account

𝐶𝑆/𝐴 = Customer Saving Account

𝐶𝐹𝐷 = Customer Fix Deposit

𝐶𝐵−𝐵𝑜𝑛𝑑 = Customer Bank Bond

𝑃𝑐𝑖𝑡𝑦 = Public of city




𝐶𝑅𝐷 = Customer Recurring Deposit

𝐶𝐸𝐿 = Customer Education loan

𝐶𝐻𝐿 = Customer Home loan

𝐶𝐶𝐿/𝐵𝐿 = Customer Car loan or Bike loan

𝐶𝐿𝐴−𝑀𝑃 = Customer loan against Mortgage Property

𝐶𝐿𝐴−𝑁𝑆𝐶/𝐾𝑉𝑃/𝑅𝐵𝐼−𝑅𝐵/𝐿𝐼𝐶/𝑀𝐹 =Customer loan against NSC/KVPs/RBI-Retail Bond/

LIC/Mutual Funds etc.

𝐶𝑃𝐿−𝑆𝐶𝐻 = Customer Personal loan Schemes

𝐶𝑂𝐷/𝑊𝐶𝐿 = Customer Over Draft and Working Capital loan

𝐶𝐿𝐴−𝑆/𝐷/𝐵 = Customer loan against Shares, Debentures and bonds

𝐶𝐿𝐴−𝐺𝑂 = Customer Loan against Gold Ornament

P/L = Profit and loss

NA = Not Applicable

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Conventional Banking Vs Islamic Banking—Comparative Analysis of the Dynamics of Operations

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