Compare and Contrast between Islamic and Conventional Banking - Term Paper Example

? Compare and Contrast between Islamic and Conventional Banking Compare and Contrast between Islamic and Conventional Banking Islamic banking and traditional banking differ from each other in terms of interest, investment and taxation. This paper seeks to delve in to the world of conventional and Islamic banking, seeking out the similarities and differences between the two areas of banking. I will first explain the Islamic banking style and then the conventional way of banking. I will then discuss the similarities and then the diversities between the two banking systems. Islamic banking is an area that has bourgeoned to become a progressively considerable sector within the international fiscal market. It has been acknowledged as a feasible and competitive system of financial intermediation, not only in Muslim republics but also outside the Muslim domain, proposing an extensive array of financial products and services (Quresh, Hussain & Rehman, 2012). Conventional banking refers to the idea of banking that is widely practiced and is inclusive of interest rates. Interest (Usury/Riba) Islamic laws (Shari’a) profoundly prohibit “interest” but do not forbid all advantages on capital. Shari’a law modestly necessitates that the performance of capital must be taken into contemplation when recompensing capital. Consequently, in financial lingo, the use of capital must augment value and not be bereft of risk (Abdi, 2010, p 76, 77). Riba (interest) is the “premium” that must be paid by the borrower, to the lender along with the principal amount, as a condition for the loan, or for an extension in the duration of loan. Riba is a monetary advantage without a counter value, which has been stipulated in favor of one of the two contracting parties’ (Abdi, 2010, p 78). Furthermore, at least four characteristics define the prohibited interest rate: It is positive and fixed ex-ante; It is tied to the time and the amount of the loan: Its payment is guaranteed regardless of the outcome or the purposes for which the principal was borrowed, and the state apparatus sanctions and enforces its collection (Abdi, 2010, p 78). Reasons for banning interest in Islamic banking The prohibition of interest is not due to any formal economic theory as such, but is directly prohibited by Divine order in the Quran. Yet, riba or interest is not precisely defined in the Quran at the time of its prohibition. The prohibition of interest is generally understood to refer to any increment over and above the principal. It represents the return on transactions involving exchange of money for money, or an addition, because of delay in payment, to the agreed price on sale debts/debts. From an Islamic point of view under some concept of fairness, there are two dimensions: the supplier of capital possesses a right to reward, but this reward should be commensurate with the risk and effort involved and should be determined by the return realized on the individual project for which funds are supplied (Abdi, 2010, p 80). One of the primary rationales espoused by Muslim scholars is that the existence of riba (interest) in the economy is a form of economic exploitation, which violates the core Islamic teaching of social justice. Therefore, the elimination of interest from the economic system would be more “fair” and ethically and morally more appropriate economic behavior. The prohibition of interest (riba) and permission of trade drive the financial activities in an economy towards asset-backed businesses and transactions. This implies that all financial transactions must be representative of real transactions for the sale of goods, services or benefits (Abdi, 2010, p 81). Interest-free loans (alternative for usury) Islamic financial institutions must not only focusing on maximizing profit, but they should also play a vital role in addressing socio-economic issues such as poverty reduction and improvements in important aspects of human welfare (like education, illiteracy, reducing child mortality, youth insecurity and restlessness, etc.). Channeling financial resources towards productive opportunities helps in enhancing production, investment and trade activities (Asyraf, 2008, p 145). Banks cannot depend only on financial performance to survive in this ever-changing scenario of global competition, but owes a social responsibility to the various stakeholders in which they exist. Based on the positive results on expectations and perceptions of diverse stakeholder groups towards the social-welfare dimensions of Islamic banking practice, as evidenced in this study, managers need to be convinced that social-welfare and profit maximization objectives need not be conflicting goals. Instead, commitment towards various social-welfare initiatives and programs could be used as a strategic marketing tool to enhance reputation and secure stakeholders allegiance, which is beneficial and profitable for the business in the end (Asyraf, 2008, p 145). Investment Types of product and services that are allowed This concludes that IBs are facing excessive contest, as CBs are also started offering IB counters (Haque & Osman et al, 2009). Hence, it is extremely imperative for IB participants to enhance and develop Islamic banking sector to compete in the market. Consumer prefer to handle its dealings by IB due to religious factor it is not true. It is also examined that IB services and products will not be prominent to commercial consumers except their overheads are lesser than the services and products of the CBs (Sudinharon & Ahmed, 2001). Likewise, Osman et al. (2009) confirmed that to be competent in the banking industry Islamic banks must have to proffer valuable services, products and competencies to contend with conventional banks instead of just compromise at Islamic emergence, appearance and image. These facts are the attractive factors, which compel to consider the important factors, which convince consumers to compact with Islamic banks. Taking account an extensive literature review, it has been noticed that no study is available to find out the important prospective factors, which influence customers to deal with Islamic banking services and products. Thus, it will be an involvement to entire people of Pakistan especially within area of Islamic banking. In addition, this research is the expansion of results of a previous study, which only took the sample of the college students (Almossawi, 2001). On the other hand, the current study tries to find out to employ significant demographic features with the help of earlier literature. Additionally, the present study explored the impact of religion perspective while selecting a bank by individual customer for its transactions. As well, (Almossawi, 2001) observed the assortment criterion of consumers in commercial banks while this research examined in the perception of both banking systems with more focus on Islamic banks and see how its effects the selection criterion in Islamic civilization approaching Pakistan. The study is determined to answer a question whether Islamic banking is becoming popular among businesses and individuals because of religion or due to its repute and benefits offered to customers and clients (Quresh, Hussain & Rehman 2012). The principle of sharing loss between (debtors and creditors) In profit-sharing contracts, lenders (investors) and borrowers (entrepreneurs) agree to share any profits from financed projects upon an agreed ratio in advance. However, losses will be shared based on contributed capital (Iqbal & Llewellyn, 2002). Generally, equity financing under non-Islamic finance, savers would provide funds to enterprises in return for a share in its prospective net returns as well as a share in its management. However, in contrast, profit sharing funding of projects under Islamic finance is not for the whole life of the financed enterprise, but for a shorter period, as in the case of providing working capital. Profit sharing finance may be provided with and without sharing in management, Linked with profit sharing is the notion of risk sharing. This is based on the principle of liability, which states that profit is justified based on one’s obligation to take a loss. This legal maxim is said to be derived from a saying of the Prophet Mohammed that “profit comes with liability” implying that Shari’a distinguishes lawful profit from all other forms of gain. One becomes entitled to profit only after one bears the liability, or risk, of loss (Abdi 2011, p 88, 89). Tax in Islamic banking (Zakat) Zakat- This is the requirement to benefit society through the collection of alms, which is known as Zakat (Abdi 2011, p 76). Benefits Zakat For society, fractional reserve system allows banks to act as intermediaries that facilitate the movement of funds from savers to investors in a society. There are also significant economies-of-scale in banks making investment and lending decisions, as they have access to knowledge and expertise which individual investors or lenders generally do not (Abdi, 2011:104). Fractional reserve banking provides with regulators power tools for manipulating the money supply and interest rates, which is essential for conducting monetary policies and fractional reserve banking allows either the central bank or commercial banks to create money at will, allowing the money supply to adjust to changing demand for money (Abdi 2011, p 105). Islamic banking eliminates the problem of fractional reserve requirements by mandating 100 percent reserve requirement for all current or demand deposits (demand deposits are mainly for safekeeping purposes and the banks guarantee the principal because of the 100 percent reserve provision). However, investment deposits are placed on a profit-and-loss sharing (PLS) basis. When such a bank faces macroeconomic or bank-specific shocks, investment depositors automatically share the risk. The bank is less likely to fail and bank runs are less probable. Yet, despite the benefit of risk reduction that PLS offers, Islamic banks are not immune from financial crises or failure. PLS banking can to some extent protect a bank against interest rate risk and credit risk, but not against operational risk. Problems from computer systems/software or fraudulent behavior of a bank’s officers can cause serious losses. Even if insolvency is less of a problem for PLS banking, there is little to prevent liquidity problems (Abdi 2011, p 108). Unlike non-Islamic banks, Islamic banks cannot create credit out of thin air36. Money cannot be issued without a link to production of goods and services. Investment is equal to savings, and aggregate supply of goods and services is always equal to aggregate demand. Under this setting, bank runs and wild speculations are highly unlikely since the credit creation process is severely curtailed (Abdi, 2011, p 109). Conclusion Concisely, Islamic banking system has the potential to become one of the promising sectors to realize the noble objectives of Sharia, as it resides within a financial trajectory underpinned by the forces of Shariah injunctions based transactions (Dusuki, 2010, p 146). However, the assets, bank and board size of conventional banks is higher compared to Islamic banks (Wasiuzzamn & Gunasegavan, 2013). References Abdi, A. M. (2010). Islamic Banking: Steady in Shaky Times? Dusuki, A. W. (2008). Understanding the Objectives of Islamic Banking: A Survey of Stakeholders’ Perspectives. Emerald Group Publishing Limited. Hafeez, A. Q., Hussain, Z & Rehman, K. U. (2012). A Comparison between Islamic Banking and Conventional Banking Sector in Pakistan. Information Management and Business Review, Vol. 4, No. 3, 195-204. Hanif, M. (2011). Differences and Similarities in Islamic and Conventional Banking. International Journal of Business and Social Science, Vol. 2, No. 2, 166-176. Iqbal, M. & Llewellyn, D. T. L. (2002). Islamic Banking and Finance: New Perspectives on Profit-Sharing and Risk. Edward Elgar Publishing. Wassiuzzaman, S. & Gunasegavan, U. M. (2013). Comparative Study of the Perfomance of Islamic and Conventional Banks: The case of Malaysia. Read More