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

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

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 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 Kafalah guarantee 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).

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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.