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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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, %he prohibition of interest based
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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, %he prohibition of interest based
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$s risk "hereas the borro"er takes upon
himself all sorts of risks in addition to his skills and labor
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, %he prohibition of interest based
transactions
8iba violates the principle of property rights
(oney lent on interest is used either productively that it
creates additional "ealth or other"ise When money used
-together "ith labor and entrepreneurial skills. to produce
additional "ealth* such money lent cannot have any
property rights claim to the incremental "ealth becausethere "as no prior bargain over it Instead =interest$*
demanded a guaranteed return regardless of the enterprise
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, %he prohibition of interest based
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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, %he prohibition of interest based
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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& #voidance of speculations -+harar.
• (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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& #voidance of speculations -+harar.
+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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& #voidance of speculations -+harar.
• 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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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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Comparison of Islamic "ith
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
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