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Impact of Islamic and

Conventional banks on
Small Entrepreneurs
A Research Study
Group Members Names:
Fahad Mustafeez
Maryam Riaz
Umer Farooq
Agha Rizwan

Currently there are two major types of banking being conducted around the world,
Conventional or with interest banking and Islamic or interest free banking. Each of
these two different types of banking has their own ethos and attributes. What
distinguishes these two types mainly is the acceptance of interest in the
Conventional system and on the other hand the total rebuttal of interest from the
banking system in the Islamic system. Islamic banking has been around since the
1970s when it was initially tried out as an experiment in a small town in Egypt
and since then has been attracting a big chunk of the deposits around the world in
different banks. In some countries like Iran and Sudan the whole banking system
has been converted into an Islamic system
(European Business Review, Volume 97 Number 2 1997 pp. 92).
Many multinational banks like Standard Chartered, Citibank and HSBC have been
offering Islamic banking products to their customers over the years.
In the conventional banking system the relation between the borrower and the
lender is such that the lender or bank just provides the money or capital required by
the borrower and the borrower has to return the obtained principle amount with an
interest amount, interest is charged by the lender from the borrower as a means of
payment for having being able to use his money. On the other hand in the
Islamic banking system the lender and borrower relationship is more of a
partnership [Dar and Presley, 1999, International Journal of Islamic Financial
Services Vol. 1 No.1] with one party supplying the money or capital for
undertaking a project and the other party applying their skills and knowledge to
generate a profit, this profit (or loss) is then shared by the two parties according to
the agreed terms with no fixed payment to be made in the case of a profit or a loss.
The impact of Islamic and Conventional banks on poverty in the people living in
the Islamic countries can be substantial, the Islamic world alone consists of around
1.2 billion people and they are distributed all over the world from Senegal to the
Philippines. One of the major factors which is causing this poverty is the failure of
the Muslim governments to provide education and employment to the masses and
due to this all over the Muslim world we have to face low productivity and an
immense percentage of poverty in the masses. About 129 million people in

Indonesia are living below the poverty line of $2 per day and the situation in the
biggest Muslim countries in South East Asia namely Pakistan and Bangladesh isnt
all rosy. Approximately 122 million people live below the poverty line in both the
two countries and in India about 100 million people are below the poverty line
(IRTI, 2007, p.18).
Sources suggest that about 72 % of the people in these countries dont use the
financial system like banks and insurance companies because the financial system
is interest based and contrary to the teachings of Islam. (Karim, Tarazi and Reille,
Currently the presence of Islamic banks in these countries is limited and the
amount of business that these banks handle is over $1 Trillion and can grow to over
$4 Trillion in the coming years (Abdul Ghafoor Awan, 2009). Interest is starting to
grow towards the Islamic finance system with the current financial crisis all over
the world affecting the conventional banking system but largely the Islamic
banking system has remained safe (Abdul Ghafoor Awan, 2009), according to
Nazim Ali (2008:154) many research journals, books and papers have been written
about the Islamic finance system. The number of research papers and books written
about the Islamic banking system is 2557 and 970 respectively out of which 1187
papers and 190 books respectively were written or published in the European and
American journals and markets.
There are many factors due to which the provision of credit facilities to the poorer
population of the world has not been dubbed viable, at least for now. The first
problem in banking for the poor is the economic theory which dictates that due to
the agent principle problems of informational asymmetry, moral hazards and
adverse selection it is not possible to loan out credit to the poor as this might lead
to the collapse of the formal credit market due to the lack of trust between the
borrower and the lender as there is this notion that the contract between them will
only be honored if there is a collateral held by the lender against which they can
make claims if the payment of the loan is not made timely or wholly. Secondly a
person who has a reputation as a man of honor is applicable for a loan. Both these,
a lack of trust and a lack of information about the applicant, cause hindrances in
the way of credit provision. Unfortunately for the poor who have neither any
collaterals to give in lieu of a loan and who are generally not thought of as the
trustworthy types it is almost impossible to secure a loan.

Also most of the profit oriented banks classify the poor as un-savable or too
poor to save and no insurer is willing to insure the loan due to the uncertainty
involved with low income groups like health problems, illiteracy and the
possibility of mismanagement of funds. There are also many socio-economic and
physical barriers in the way of credit provision to poor people like lack of
infrastructure, poor healthcare and discrimination on the basis of castes, gender or
ethnicity (Humanomics Vol. 24 No. 1, 2008, pp. 50).

In this paper we are looking to making clear a connection between the two
different types of banking systems and their impact on small entrepreneurs.
Furthermore we are looking to find out which type of system will give more
benefit to the small entrepreneur and through which banking system can the end
consumer get more facilities without having to take any substantial risks which
might affect his/her future.

Literature Review:
The basic idea behind the Islamic and Conventional banking system is to obtain
deposits from customers who want safe keeping of their hard earned money and
transform them into loan-able amounts which will then be loaned out to
individuals, companies and firms. But this is where the difference begins to come
up, the Islamic banking system dictates that the money be lent to the borrower
interest free and the objective should be that the amount of money being lent will
stimulate business activity and to accelerate the circulation of wealth in a way that
even the poor have access to it as in equal distribution of wealth, while the
objective behind the lending of money in the conventional banking system is to
maximize shareholder wealth and accumulate wealth via the interest bearing
instruments (Abdul Ghafoor Awan, 2009). According to Warde 2006:136 the
conventional banking system favors the rich and the people who already have
money, but the poor have no advantage from them. But in the Islamic banking
system the capital needing people and the lender link their fate together in the
pursuit of profit or loss.
The poor people of Muslim countries have no different requirements of capital or
money as compared to other non-Muslim countries, but often the Muslim country
people are influenced by their religion and or culture to spend incessantly (IRTI,
2007, p.20) on things and events which require more cash than they have on hand.
The differences between Islamic and Conventional banking systems can be found
in various research papers. Some major differences and similarities that we have
managed to find are given below:

1. Islamic banks rely heavily on their own equity holdings to finance loans
while the conventional banks do not have to rely solely on their equity
holdings for debt transactions.
2. Islamic banks face much more difficulties in attracting customers willing to
make deposits than conventional banks.
3. Islamic banks have a much higher cash/deposit ratio because of their
conservative attitude in loaning out amounts to loan seekers.
4. There is no discrimination in Islamic and conventional banks when it comes
to profitability and efficiency.
5. Similar returns on investments are offered by both the Islamic and
Conventional banks to their customers.
6. Islamic banks and Conventional banks focus more on financing durable
goods then they do on anything else.
7. Islamic banks find it hard to finance personal loans due to the profit and loss
sharing principle.
(European Business Review, Volume 97 Number 2 1997 pp. 98)
Islamic bank and conventional banks modes of utilization of money are also
different. Conventional banks buy commodities and other assets, retain them and
then sell them out on a premium price. Margrit Kennedy and Declan Kennedy
(1995:17) maintain that although money is the need of every one. It is used to
exchange the goods and services. But it becomes a source of frustration when
people become start to worship it. They do not understand that money is not the
asset of any one person. Ideally it should circulate in the society. They say that
whenever a person falls in love with money then he cannot escape himself from
this curse easily. They become addicts of getting more and more money.
On the other hand Islamic banks spend money to purchase real assets and raw
materials to produce valuable products and share all profit with its depositors.
However they also share the loss.
The study of advanced capitalist economies has proved that during the 1960
to1998 the poorest income decrease from 2.3 to 1.2 while the income level of
richer increase 26 percent.
Gregory and Stuart (1992:87) in their book Comparative Economic System
quoted the philosopher, John Rawls, who argues that this unequal distribution of
wealth cannot be reduced from the society. Because the people who are getting
benefit from this unequal distribution of wealth are against changing this system.
Islamic banks control this type of attitude regarding wealth through collecting
zakat. The system of zakat is such that it takes money from rich people and
distributes it between the poor people.

Development of Islamic banks in Pakistan:

Pakistan was created in the year 1947 as an Islamic state and the major objective
was the elimination of Riba(interest). Article 38(f) of the Constitution of the
Islamic Republic of Pakistan provides: The State shall Eliminate Riba as early as
possible. Islamisation was started in 1980s and interest was replaced by mark-up.
Mudarabah Companies (Floatation and Control) ordinance, 1980 was enforced and
more than 30 Mudarabah Companies were launched and enlisted at Karachi Stock
Beginning of Islamic Banking:
In accordance to the Islamic banking models of Saudi Arabia, Malaysia &
Bahrain, State Bank of Pakistan established an Islamic Banking Division and
Banking Policy Department in 2001.
In 2002 Meezan Bank Ltd. was given the license to operate fully as a purely
Islamic Bank.
In Sept. 2003 Islamic Banking dept. (IDB) was established to deal with and
supervise and resolve issues incurred in Pakistani Islamic Banks.
In 2003 under the guidelines of SBP 5 more banks were allowed to do
Islamic Banking namely:
1. Bankislami Pakistan Ltd,
2. Dawood Islamic Bank Ltd
3. Dubai Islami Bank Ltd
4. Emirates Global Islamic Bank Ltd
5. Albaraka Islamic Bank (It was already functioning as a subsidiary of foreign
Islamic bank)
In December 2008, SBP allowed conventional banks to open separate
Islamic bank branches.
In 2009 there were a total of 12 Islamic banks.
Total Islamic bank branches will be 840 by 2012. ( 15, 2009)
A Banks strengths & weaknesses are measured by analyzing its balance sheet.
Conventional banks earn income through interest while Islamic banks earn profit
through equity-based financing and investment.

The basic functions of the Islamic banks are:

To get together money from the people on profit-and-loss sharing basis.
Islamic bank save the wealth of depositors by using it in financial viable and
value generating activities.
Equal distribution of wealth through allocating financial resources.
To act as a development institution.
To motive entrepreneurs by providing them with finance.
To provide expertise and technical advice to the finance-taker in order to
improve the process of production and profitability.
Distribute financing and discourage its hoarding amongst few people.

Research Method:
We have used the case study method in this research paper. The case study
research method entails that we go through many papers written by noted
scholars and then come to a conclusion for a problem.

SWOT Analysis:
By conducting SWOT analysis we see the strengths, weaknesses, opportunities
and threat of Islamic bank.
1. Caters to the Muslim population who are averse to interest payments.
2. The Islamic system isnt limited to just banking but also covers other areas
like financial instruments, markets and intermediations.
3. Are present in about 60 countries with about 250 institutions which operate
along these principles.
4. Provides better cohesion between social classes as the chances of financing
are available equally for everyone.
5. Invests in sectors which are growth oriented and have the ability to prosper.
6. Investments are secured as the banks dont use it in risky ventures.
7. The borrower is allowed to borrow a slightly smaller amount than if they
had borrowed from a conventional bank but the good thing is that the excessive
risks associated with this excessive borrowing are minimized.

1. The borrower and the lender institution suffer when the returns are not
favorable due to the profit and loss sharing principle.
2. Excessive profits cannot be earned by the banks as they have to return the
excess profit to the borrower.
3. Islamic markup instruments like Ijara and Murahaba are disputed under the
Islamic laws as they imply a fixed return on investment from the borrower.
4. Islamic banks face difficulties operating in non-Muslim countries as there
arent any Islamic regulatory bodies for their regulation.
1. The money to be lent can be lent to entrepreneurs who wish to start new
ventures rather than being spent on goods.
2. Over the years some 50% of savings will be held by Islamic banks according
to some bankers and scholars.
3. Global financial institutions are capitalizing on this niche market of Islamic
banking and have set up their own Islamic banking subsidiaries which might
cause an influx of deposits coming in to the Islamic banking systems.
4. The profitability of the banks can be increased by adopting new strategies
and techniques.
1. In the Islamic financial instruments where the bank purchases goods for a
borrower there is a problem of the goods being rejected by the borrower due to
non conformity which will leave the bank holding the goods.
2. Financial statutory and contractual liabilities like warranties might arise due
to the bank holding the goods for the customer.
3. The Islamic banking system isnt properly developed in terms of research
and information technology being incorporated into it.
References for SWOT analysis:
1. A Comparative Literature Survey of Islamic Finance and Banking
2. Al-Sultan, Waleed, Financial characteristics of interest-free banks and
conventional banks, Doctor of Philosophy thesis, Department of Accounting
and Finance, University of Wollongong, 1999.

3. Islamic Development Bank, Fourth Annual Report: 1399 H. (1979) (Jidda,

1980), p. 49

From our study we have gained much insight into the workings of both the banks
and how they provide financing opportunities to small entrepreneurs. While in
some areas the Conventional banks with their interest based dealing has the upper
hand, the Islamic banks have been providing a much better platform for the smaller
borrowers to get credit and be able to start their own ventures. The interest based
banks have better chances of their borrowings being returned as they take collateral
against every loan. The Islamic banks fare less well as the Islamic principle
dictates that no such collateral be taken. This topic has become a bone of
contention between Muslim scholars and financial institutions as now the Islamic
institutions have started taking collateral or guarantees against the loans that they
The Islamic banks have a greater part of their deposits lying idle as due to their risk
aversion they hesitate in giving loans to even a little risky ventures. They are quite
happy in just providing loans for growth oriented sectors like agriculture but they
hesitate in funding risky ventures which have the capability to provide better
returns both to the bank and the entrepreneur. Also the Islamic banks have a greater
part in the collection and distribution of zakat so that wealth isnt accumulated in a
few hands but is well distributed amongst the poor and the needy populace of the
So in our minds the Islamic banks have a better understanding of the needs of the
small entrepreneurs and more suitable for these entrepreneurs due to their profit
and loss sharing principle.

1. A Comparative Literature Survey of Islamic Finance and Banking, By Tarek
S. Zaher And M. Kabir Hassan
2. Al-Sultan, Waleed, Financial characteristics of interest-free banks and
conventional banks, Doctor of Philosophy thesis, Department of Accounting
and Finance, University of Wollongong, 1999.
3. Islamic Development Bank, Fourth Annual Report: 1399 H. (1979)
(Jidda,1980), p. 49
4. European Business Review, Volume 97 Number 2 1997 pp. 98
5. Abdul Ghafoor Awan, Comparison of Conventional and Islamic banks,2009
6. January 15, 2009
7. Gregory and Stuart Comparative Economic System (1992 pg: 87)
8. IRTI, 2007, p.20
9. Warde 2006 pg:136
10. Humanomics Vol. 24 No. 1, 2008, pp. 50
11. Nazim Ali 2008 pg: 154
12. Karim, Tarazi and Reille, 2008.
13. Dar and Presley, 1999, International Journal of Islamic Financial Services
Vol. 1 No.1.
14. Diagram reference: Banking for the poor: the role of Islamic banking in
microfinance initiatives by Asyraf Wajdi Dusuki pg: 54