Islamic Banks and Conventional Banks, How Do They Differ?
By Mohammed Waseem
Islamic Banking is a banking system based on Islamic Shari’ah principles which are different from the principles followed by conventional banks. I would like to write about the products offered by Islamic banks, but before that, I will write about the differences between Islamic banks and conventional banks. So, in this article, I will discuss how Islamic banking is different from conventional banking.
Although many products offered by Islamic banks are similar to those offered by conventional banks such as deposits, equity, etc. but the two entities differ conceptually and both have different business models. The major difference is that conventional banks cannot exist without dealing in interest while Islamic banks prohibit interest-based dealings.
Conventional commercial banks give loans on a certain percentage interest as their return, they accept deposits and give out fixed percentage of compounded interest to depositors and invest the deposited money or give out loans, they offer credit cards and so on. Islamic banks earn their money from profit and loss sharing, trading, leasing, charging fees for services, etc. which are guided by the principles of the Shari’ah.
While interest is the bloodline of conventional banks and some level of speculation takes place therein, Islamic finance is based on four core principles: prohibiting usury, avoiding speculation, avoiding gambling and investing ethically. Islamic commercial banks are monitored by a Shari’ah board, which consists of Islamic scholars who are qualified to give opinions on Islamic business contracts. This is not true in case of conventional banks, which have a board just like any other business organization which takes business decisions.
Islamic banks operate based on Islamic business law (Fiqhul Mu’amalaat in Arabic) and they also follow the financial laws and regulations of the countries they operate in. Likewise, conventional banks operate based on financial laws and regulations of the country of operation, but have no association or contact with any religious body.
The concept of time value of money is very important in conventional banking. According to the financial laws, the value of money increases as time passes. This difference in present and future values is what is conceptually called interest. According to Islamic laws, the concept of time value of money is invalid because according to it, the value of money remains same, regardless of the time. Past or future, a dollar is a dollar. Additionally, money is not a commodity but a medium of exchange and store of value.
Another difference is that the relationship between customer and a conventional bank is that of a debtor and a creditor. This is not always true in Islamic banks, where, in a few cases it is that of partnership. Money received from depositors is invested by the Islamic banks in any Shari’a based or Shari’ah compliant mode, to earn profit. This profit is shared with the depositor in a predetermined ratio. In case of loss (which rarely happens because Islamic banks choose investments wisely), the depositor has to bear that, too. In other words, Islamic banks don’t provide a guaranteed return as in case of conventional banks.
These were a few key differences between Islamic banking and conventional banking systems. In the next few articles, I will write about Islamic banking products in detail.