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Four Ways Conventional and Islamic Commercial Banks Differ

Although Islamic commercial banks have many products similar to those offered by conventional banks, the two entities differ conceptually. One key difference is that conventional banks earn their money by charging interest and fees for services, whereas Islamic banks earn their money by profit and loss sharing, trading, leasing, charging fees for services rendered, and using other sharia contracts of exchange. Following are four key ways that conventional and Islamic commercial banks differ.

The oversight of a sharia board

A sharia board consists of Islamic scholars who are qualified to give opinions on Islamic business contracts. In a commercial bank, the board is also involved in supervising bank operations to make sure they comply with sharia principles. ou may wonder why a bank needs a sharia board to ensure its compliance with sharia principles. If the basic distinction between conventional and Islamic banking hinges on interest, can!t Islamic banks satisfy the requirement by "ust making sure none of their transactions involves charging interest# Islamic banks and other financial institutions must comply with a variety of principles besides avoiding interest. Islamic finance is based on four core principles$

%rohibiting usury Avoiding speculation Avoiding gambling Investing ethically

Interpreting each principle is more difficult than you may think. &cholars spend their lifetimes learning all they can about the intent and past interpretation of sharia law, and they still often have differing opinions about it. 'aking sure that Islamic banks comply with sharia isn!t easy ( hence the necessity of the sharia supervisory board. )his board is the backbone of an Islamic bank* it plays a vital role in establishing and operating the bank.

Concepts of money and the basis of transactions

)o say that Islamic banks are different from conventional banks because the former don!t charge interest is accurate, but it!s only the tip of the iceberg. )hat difference is "ust one of many ways that the fundamentals of Islamic banking differ from those of conventional commercial banking.

)he basic purpose for establishing an Islamic bank is to promote and encourage Islamic principles. +onventional banks are profit,making organi-ations that generally aren!t based on religious principles. )hat said, earning money is also a primary function of an Islamic commercial bank. Although the bank has a specific religious purpose, it can!t serve that purpose unless it also meets the ob"ective of earning money. A bank serves no purpose at all if it can!t stay in business. Islamic banks operate based on Islamic business law /called fiqh-u-muamalat0 for their basic transactions, and they also follow the financial laws and regulations of the countries in which they operate. +onventional banks likewise operate based on a country!s financial laws and regulations, but they don!t have contact with any religious body. Islamic scholars recogni-e that money has value, but with limitations. For example, money can!t become more valuable simply because time is passing. 1owever, the value of money can increase if it!s invested in a pro"ect that itself is increasing /in si-e, in success, and so on0.

Relationships with clients or customers

2hen you deposit your paycheck in a conventional bank, your relationship with that bank is one of creditor to debtor* the bank has a responsibility to pay back your money with or without interest according to your account contract. &imilarly, the roles reverse when the bank provides you with a loan. )he relationship between a customer and an Islamic bank is completely different* the debtor and creditor relationship does exist at times in Islamic banking. )o understand the relationship between the customer and Islamic bank, you must know what contract that relationship is based on.

Investments in the bank

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 345,555 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. 6ven 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. &uppose 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 customer.

/Note: )he failure of an investment isn!t very common in Islamic banks because the banks are very concerned about their customers and make their investment choices very wisely. If they didn!t, they soon would have no customers at all.0

1. The functions and operating modes of conventional banks are based on fully manmade principles. 2. The investor is assured of a predetermined rate of interest. . It aims at ma!imi"ing profit without any restriction. $. It does not deal with Zakat.

1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah. 2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur). . It also aims at ma!imi"ing profit but sub#ect to Shariah restrictions. $. In the modern Islamic banking system, it has become one of the service%oriented functions of the Islamic banks to be a Zakat &ollection &entre and they also pay out their Zakat. '. )articipation in partnership business is the fundamental function of the Islamic banks. *o we have to understand our customer+s business very well. ,. The Islamic banks have no provision to charge any e!tra money from the defaulters. -nly small amount of compensation and these proceeds is given to charity. .ebates are give for early settlement at the /ank+s discretion. 0. It gives due importance to the public interest. Its ultimate aim is to ensure growth with e2uity. 3. 4or the Islamic banks, it must be based on a *hariah approved underlying transaction. 5. *ince it shares profit and loss, the Islamic banks pay greater attention to

'. (ending money and getting it back with compounding interest is the fundamental function of the conventional banks. ,. It can charge additional money (penalty and compounded interest) in case of defaulters.

0. 1ery often it results in the bank+s own interest becoming prominent. It makes no effort to ensure growth with e2uity. 3. 4or interest%based commercial banks, borrowing from the money market is relatively easier. 5. *ince income from the advances is fi!ed, it gives little importance to

developing e!pertise in pro#ect appraisal and evaluations. 16. The conventional banks give greater emphasis on credit%worthiness of the clients. 11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors. 12. 7 conventional bank has to guarantee all its deposits.

developing pro#ect appraisal and evaluations. 16. The Islamic banks, on the other hand, give greater emphasis on the viability of the pro#ects. 11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller. 12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position..